Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?

Abstract

Abstract: The roles of Fannie Mae and Freddie Mac have become increasingly controversial in the modern world of residential mortgage finance. The authors describe the special features of these two companies and their roles in the mortgage markets and then discuss the controversies that surround the companies and offer recommendations for improvements in public policy. JEL classification: G21, G28. Key words: Fannie Mae, Freddie Mac, government-sponsored enterprises, residential mortgages, securitization, regulation The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation--commonly known as Fannie Mae and Freddie Mac, respectively (1)--have led the way in dramatic changes that have taken place in the structure of the U.S. residential mortgage markets since the 1970s. Fannie Mae and Freddie Mac are quasi-private/quasi-public: for example, they have federal charters that confer unique regulatory provisions; but their shares are publicly traded on the New York Stock Exchange. The biggest advantage of Fannie Mae's and Freddie Mac's anomalous legal status arises because financial markets treat their obligations as if those obligations are backed by the federal government--even though the federal government explicitly does not do so. With the benefit of this special status, Fannie Mae and Freddie Mac have grown into enormous financial institutions, with combined total assets of over $1.8 trillion in 2003. One critic, Richard Carnell (2004), a former Assistant Secretary of the Treasury, has suggested that the two companies' growth is at least partially a consequence of a double game that they play: [They] tell Congress and the news media, 'Don't worry, the government is not on the hook'--and then turn around and tell Wall Street, 'Don't worry, the government really is on the hook.' The preferential legal status of Fannie Mae and Freddie Mac serves as one of a number of mechanisms by which the federal government encourages the consumption (and, arguably, the over-consumption) of housing in the U.S. economy--this one with an on-budget cost of zero. But economists are congenitally suspicious of programs that seem to offer something for nothing. After all, a federal of the deposits in savings and loans cost nothing for many decades--until the early 1990s, when it cost taxpayers about $150 billion (U.S. Federal Deposit Insurance Corporation, 1997). Furthermore, Federal Reserve Chairman Alan Greenspan (2004), among others, has suggested that the anomalous situation of Fannie Mae and Freddie Mac may even pose systemic risks to the financial sector. This article will offer a generalist's guide to the functions that Fannie Mae and Freddie Mac perform in the residential mortgage financial markets and the controversies that swirl around them. Along the way we will highlight some important--and perhaps under-appreciated--changes that are occurring in the structure of U.S. residential mortgage markets. Some Background What Do Fannie Mae and Freddie Mac Do? Fannie Mae and Freddie Mac participate in the secondary mortgage market: Mortgage originators come to them with pools (bundles) of mortgages and either these assets for securities or sell them outright to one of the two companies. Under Fannie Mae's and Freddie Mac's swap programs, an originator exchanges a mortgage pool for a mortgage-backed security that is issued and guaranteed by one of the two companies and that represents an interest in the same pool. Fannie Mae and Freddie Mac promise the security holders that the latter will receive timely payment of interest and principal on the underlying mortgages, less an annual guarantee fee of about 20 basis points (0.20 percent) on the remaining principal. In essence, Fannie Mae and Freddie Mac are providing insurance to holders of mortgage-backed securities against default risk on the underlying mortgages and are thus bearing that risk themselves. …