Fannie Mae and Freddie Mac

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Loan Corporation (Freddie Mac) were originally chartered by the U.S. government but have since become private corporations. They are key players in the U.S. housing market. Home prices can only go up if there are new mortgage loans available at the increased price. Enter Fannie Mae and Freddie Mac. Here’s how they facilitate the housing bubble.

In most cases, a home buyer does not have the cash to purchase a home, so he takes out a mortgage from a bank, savings and loan association or other mortgage lender. These institutions that originate the loan are known as primary lenders. The primary lender can hold on to the loan until maturity (usually 30 years), collecting principal and interest payments during this time. Or, it can sell the loan in the secondary market to corporations such as Fannie Mae or Freddie Mac. This gives the primary lender cash which it can use to originate a new mortgage. The process repeats itself over and over.

But where do Fannie Mae and Freddie Mac get their money? Either they issue corporate bonds (and use the proceeds from these bond sales to buy the mortgages) or they sell previously acquired mortgages which are grouped together into mortgage-backed securities (derivative-like instruments) to third parties such as insurance companies, mutual funds or pension funds. These third parties then receive the income stream from the underlying principal and interest payments.

Fannie Mae has even gone one step further—taking the mortgage-backed securities and grouping them again into more complex derivatives called Real Estate Mortgage Investment Conduits (remics). “Approximately half of all Fannie Mae’s [mortgage-backed securities] have been transformed into these highly speculative remic derivative instruments.

“Thus, what started out as a simple home mortgage has been transmogrified into something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds” (Executive Intelligence Review, June 21, 2002).

Fannie Mae and Freddie Mac are probably the top two private company debt holders in the world. Together they now own over $4 trillion of debt linked to home mortgages—more than 75 percent of single-family mortgages in the U.S. This dominance of the housing market by just two corporations disturbs many, including Federal Reserve chairman Alan Greenspan.

In a speech to the Senate Banking Committee on February 24, he suggested that these companies have an unfair competitive advantage because they are perceived to be backed by the federal government even though they are not. He warned that they are expanding at a pace that could threaten the stability of the entire financial system should either of them get into trouble! (Freddie Mac has already admitted to overstating profits by nearly $1 billion in 2001.) Greenspan further admonished that the companies should stick to core competencies and avoid branching out into complex derivatives.

Currently, the companies are regulated by the Office of Federal Housing Enterprise Oversight (ofheo), which has limited oversight powers. Greenspan urged the Senate Committee to create a tough new agency to more directly supervise the two companies and advised them that “preventative actions are required sooner, rather than later.” However, Fannie Mae and Freddie Mac have powerful lobbyists in the halls of Congress. Previous efforts to control them have been fruitless.

On September 22, just seven months after Greenspan’s admonition, ofheo released a shocking report. It documented how Fannie Mae’s top management intentionally rigged expenses in order to earn higher bonuses, meet financial forecasts and most importantly, stabilize earnings. One executive admitted this was done “to make sure Fannie [Mae] would be perceived as a low-risk enterprise” (BusinessWeek Online, September 23).

The demise of either or both of these companies because of a severe housing bubble bust or other financial problems would generate a colossal catastrophe for the banking system, mutual funds, pension funds and the U.S. economy.