Fannie and Freddie
What is it?
It's more a question of what are they? The answer is a strange kind of hybrid. Fannie Mae and Freddie Mac are a mixture of private company and government-backed enterprise (also known as 'Government Sponsored Enterprises' or GSEs). Both are big players in the mortgage industry and occupy a pivotal role in the American housing market.
Fannie came first: it was formed in 1938 by Franklin Roosevelt to ensure there were lots of mortgage funds available during the Great Depression. Initially, it was a government-owned company, but it was converted into a private organisation and listed on the stock exchange in 1968.
Freddie Mac was formed in 1970 as a competitor for Fannie.
What do/did Fannie and Freddie do? Their main purpose is/was to buy up mortgages that were issued by US banks to US households, thereby pumping cash into the housing system. Fannie and Freddie pretty much invented the concept of securitization which is held to be responsible for many of the woes of the credit crunch.
In mid-2008, Fannie and Freddie were buying up three quarters of all US mortgages. Under the securitization model, US banks sold Fannie and Freddie the mortgages they'd extended to US householders, along with the right to receive the future stream of interest payments from the householders who'd taken the mortgages out. Fannie and Freddie then issued asset backed securities based on those promised future payments and sold the ABS to investors.
What if US householders never paid their mortgages? This could be dire for Fannie and Freddie, which were obliged to buy back any mortgages that were not being paid and which they'd used as collateral for ABS. However, there was an implicit - but never a written - guarantee that if Fannie and Freddie ever ran into serious problems of this kind, the US government would come to the rescue. If it didn't, ABS issued by Fannie and Freddie could plummet in value and investors would be left with little or nothing.
This implied guarantee is/was crucial to Fannie and Freddie's business model. Before they could buy the mortgages from mortgage banks, they needed to raise money. And when they raised this money, they were able to borrow very cheaply - at rates usually reserved for the US government. Investors didn't charge much to lend Fannie and Freddie money because it was thought that the US government would prevent them defaulting on their debt.
Because mortgage-paying households paid a higher interest rate, Fannie and Freddie were therefore able to make a profit: they themselves borrowed at low rates, and effectively lent money at higher rates.
However, a lot of the money that Fannie and Freddie themselves borrowed was in the form of short-term loans - usually for three to six months. As a result, the two agencies were forced to issue new debt frequently in order to pay off their old debt. And if no one wanted to buy that new debt? Fannie and Freddie would be in big trouble.
What have they got to do with the financial crisis?
Neither Fannie nor Freddie had anything to do with the US sub-prime mortgage market directly: both were only permitted to buy mortgages that had been extended to households with strong credit histories. Despite this, both agencies stepped beyond their original remit and began buying ABS backed by mortgages that were issued by other organisations. And those ABS were related to sub-prime.
As a result, in 2007 both Fannie and Freddie had writedowns of $5bn-$6bn, according to The Economist. And as economic conditions worsened, there was a danger that even Fannie and Freddie's reliable households would stop paying their mortgages.
At the same time, the credit crunch made investors wary of dealing with organisations that had poor capital adequacy ratios, and Fanny and Freddie were barely capitalised at all. In July 2008, their core capital was only around 1.5% of the $1,500bn of debt they held, compared to around 4% for most commercial banks.
This house of cards came tumbling own in July 2008, when a former president of the Federal Reserve Bank of St Louis said Freddie Mac owed more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules.
The stock price of Freddie Mac promptly plummeted and investors started to speculate whether the US government really would guarantee all that debt as implicitly promised.
If the government had refused, there was a danger that Fannie and Freddie would have been unable to sell the short-term debt they needed to survive (Freddie needed to sell $3bn in short-term notes shortly after the crisis erupted), that the American mortgage market would have dried up (even more than it had already), and that the US housing market would have gone even further downhill (than it had already), leading to more mortgage defaults and more credit problems later on.
As a result, the US government was obliged to step in. Initially, the Federal Reserve promised to give Fannie and Freddie access to the discount window - effectively the two agencies could then issue debt and swap it for loans from the government. And in July 2008, Congress agreed to lift the ceiling on US government debt by a massive $800bn to allow the Treasury to lend to Fannie and Freddie and even to buy their shares if necessary.
However, neither of these measures proved sufficient. Fannie and Freddie's share prices kept on falling and doubts remained about their ability to survive. As a result, in September 2008, the US government intervened decisively.
The US Treasury acquired $1bn of preferred shares in each company and pledged to provide as much as $200bn to help Fannie and Freddie cope with losses related to mortgage defaults.
Most people agreed that the move was unavoidable: without it, the US mortgage market would have been worse off than it already was. Equally importantly, international investors (who owned around $5 trillion of mortgage backed securities owned by Fannie and Freddie) could have lost confidence in US financial products if the government had allowed the two companies to default on their debt.
The government has gone several steps further than that, with the Federal Reserve arranging to buy $1.25 trillion of Fannie and Freddie mortgages and debt, bringing to a total $1.45 trillion the amount the US government has spent propping up Fannie and Freddie. That's an especially astonishing figure compared to the agencies' profits. As Bloomberg columnist Jonathan Weil noted, "from 1990 through 2007, before they were seized by the government, Freddie and Fannie reported total net income of $35.9 billion and $59.8 billion, respectively." Because of the level of government support, Fannie and Freddie received the stamp of "explicit" government support backing their debt in 2008. Despite this, in 2009 a powerful mortgage bankers' association called for Fannie and Freddie to be abolished and asked the government to provide an explicit guarantee for their debt.
Last updated on 7 September 2009.
