Meet Fannie Mae and Freddie Mac

Who are these folks?  With such nice, friendly, down-home sounding names, I expect they are really wonderful people.  As a native Texan, I automatically like people who answer to two first names.  My parents did not bless me with two names that roll off the tongue, so some of my friends have christened me Jim Bob.

I spent more decades than I care to mention in the financial services business, so it was only natural that friends asked if I knew Fannie Mae and Freddie Mac.  Seems they kept hearing about them on the nightly news.   They mentioned that news commentators did not seem to know much about them either.  What is their last name, for example?  Are they married?  Why do we have to bail them out?

Since Fannie and Freddie have moved into our living rooms, maybe we should get to know them better.  Recent legislation (passed by a huge margin in the House) and now headed for the Senate allows these folks not only into our living rooms but also into our pocketbooks.  You might be surprised to learn that between the two of them, they own or guarantee almost half of the nation's mortgage market. Along with the FHA (Federal Housing Administration), they accounted for ninety per-cent of all the mortgages issued in the second quarter of 2008.  Enough statistics.  These people are not what they seem.

A lot of us know about FHA and VA loans.  I got my first house with an FHA guarantee from a Savings and Loan (remember them?).  A fair premium was added to my interest rate to pay for the FHA guarantee.  Worked great.  So why are Fannie and Freddie sick?  Why do we have to pay to get them well again?

First, Fannie is getting pretty old.  She was born in 1938 as part of FDR's New Deal.  Her real name is Federal National Mortgage Association.  Uh-oh.  She was created to bring liquidity to the mortgage market (help lenders loan money to folks who needed a house).  In those early days, she did this by either buying the mortgages or guaranteeing them.  That is an oversimplification, but explaining it further would overly complicate it, and those days are gone, anyway. 

Fast-forward to 1968 when the government decided that it did not want Fannie Mae in its house (on its balance sheet) anymore.  She was changed to a private corporation and the responsibility for guaranteeing mortgages was transferred to Fannie Mae's sister Ginnie Mae (Government National Mortgage Association or GNMA).  Uh-oh, again.  Ginnie provides guarantees for mortgages associated with FHA, VA, and other government organizations.  Wait a minute, you say.  Aren't those FHA mortgages already backed by the government?  Well, yes.  But GNMA provided the vehicle for the bundling or pooling of these mortgages into securities (also called bonds).  GNMA guarantees those securities, which are traded like other bonds on the market.   Whew.

So what happened to poor Fannie, cast off by the government?  She started doing her own guaranteeing of securities and charging a fee for it.  Fannie was now called a GSE (Government-Sponsored Enterprise).   As a private corporation, Fannie no longer offered the security of a government-backed guarantee -- but most folks continued to think she did.  It was only natural to assume that government-sponsored meant government-guaranteed. 

We have not forgotten Freddie Mac. His full name is Federal Home Loan Mortgage Corporation.  Uh-oh again.  He was formed in 1970 to provide competition for Fannie in what had now become the secondary mortgage market.  I suppose that Congress, in its infinite wisdom, did not want to give a single GSE an unfair advantage.  They want all of us to be the same.  Besides, this bundling of mortgages into securities and selling guarantees that were really not worth much was really heating up and was very profitable.  People were buying homes and lenders were making loans they felt were fail-safe.  They felt so safe in fact; that they dropped customary lending practices and started making loans to anybody who could fog a mirror.  At twenty-four, I was not a great risk when I bought my first home, but I had to meet standard criteria (down-payment, income, good credit, etc) to get my loan. Even with an FHA guarantee.

Competition heated up between Fannie, Freddie, banks, mortgage companies, and brokers.  Everyone wanted in on the act.  Money flowed; greed controlled.  Mortgages were no longer personal transactions between a borrower and a lender; they were lumped together and became impersonal bonds -- bonds that investors loved.  They also loved owning stock in Fannie and Freddie. 

Recognizing a good thing when they saw it, Fannie and Freddie (now headed by CEOs who seemed to have extraordinary political connections or political positions on their resumes) branched out into derivatives.  Don't ask.  Ok, short answer is these are securities derived from the underlying pooled bonds.  Risk is higher.  I don't have enough space to explain more.  Lending went wild.  An almost new profession of mortgage broker had been created.  His job was to sell mortgages for a commission.  A lot of these brokers were fresh out of college and in their first jobs.  Most had little regard for whether these mortgages would be repaid.  After all, they would never hear from the lender or borrower again.  Commissions were good, executive bonuses went into the stratosphere.

The mortgages instantly left the lender on a fast train to see Fannie and Freddie, who instantly turned them into securities and put them on the market as bonds.   Stockbrokers sold the bonds and unwitting investors scooped them up.  Who noticed or cared when the occasional borrower defaulted? 

So, how does Congress correct this mess?  Who pays for the bad loans?  Congresspersons, most of whom think a derivative is an after-dinner drink, blame everybody but themselves.  Democrats almost wholly blame predatory lenders and greedy brokers, citing the need for more regulation.  How about another sibling for Fannie, Freddie and Ginnie?  Others, including some Republicans, blame greedy buyers who bought houses they could not afford in order to "flip" them when prices continued their never-ending climb.  Well, prices did not continue their climb. 

As for me, I blame them all.  But most of all, I blame Congress.  They created this mess of bureaucratic organizations.  They are guilty on multiple counts.  With the worthwhile intention of making it easier for people to own their own homes, they interfered in the markets and unwittingly encouraged greed, poor business practices, and the creation of weak securities.  Most of all, they discouraged acceptance of personal responsibility for one's acts.  A chicken in every pot, a car in every garage (a two or three car garage, by the way), a home you can't afford.  Elected Senators and Representatives have a time horizon that does not extend past the next election.  Some have a horizon only as far as cocktail hour.  They do not understand the law of unintended consequences. 

Congress and the Federal Reserve have unrelentingly kept up a steady march to make mortgages available to everyone.  From the Community Reinvestment Act of 1977, which encouraged faulty lending practices (demanded them), to the formation of GSE's, to the encouragement of interest rates below what the market should allow, to indirect and direct subsidies to GSE's, the government, in all of its machinations, caused this crisis.  Now, they are rewarding this bad behavior by bailing out irresponsible lenders and borrowers.   Have you noticed the new commercials for mortgages?  Bad credit, not to worry.  Reward bad behavior and you get more of it.  You and I pay the price. 

Jim H. Ainsworth a former CPA, CFP, CLU, Registered Investment Advisor, Licensed Securities Principal, was twice named one of the most influential accountants in America by Accounting Today magazine.  He is the author of eight books and hundreds of articles.  He has also ridden horseback across Texas. 
Who are these folks?  With such nice, friendly, down-home sounding names, I expect they are really wonderful people.  As a native Texan, I automatically like people who answer to two first names.  My parents did not bless me with two names that roll off the tongue, so some of my friends have christened me Jim Bob.

I spent more decades than I care to mention in the financial services business, so it was only natural that friends asked if I knew Fannie Mae and Freddie Mac.  Seems they kept hearing about them on the nightly news.   They mentioned that news commentators did not seem to know much about them either.  What is their last name, for example?  Are they married?  Why do we have to bail them out?

Since Fannie and Freddie have moved into our living rooms, maybe we should get to know them better.  Recent legislation (passed by a huge margin in the House) and now headed for the Senate allows these folks not only into our living rooms but also into our pocketbooks.  You might be surprised to learn that between the two of them, they own or guarantee almost half of the nation's mortgage market. Along with the FHA (Federal Housing Administration), they accounted for ninety per-cent of all the mortgages issued in the second quarter of 2008.  Enough statistics.  These people are not what they seem.

A lot of us know about FHA and VA loans.  I got my first house with an FHA guarantee from a Savings and Loan (remember them?).  A fair premium was added to my interest rate to pay for the FHA guarantee.  Worked great.  So why are Fannie and Freddie sick?  Why do we have to pay to get them well again?

First, Fannie is getting pretty old.  She was born in 1938 as part of FDR's New Deal.  Her real name is Federal National Mortgage Association.  Uh-oh.  She was created to bring liquidity to the mortgage market (help lenders loan money to folks who needed a house).  In those early days, she did this by either buying the mortgages or guaranteeing them.  That is an oversimplification, but explaining it further would overly complicate it, and those days are gone, anyway. 

Fast-forward to 1968 when the government decided that it did not want Fannie Mae in its house (on its balance sheet) anymore.  She was changed to a private corporation and the responsibility for guaranteeing mortgages was transferred to Fannie Mae's sister Ginnie Mae (Government National Mortgage Association or GNMA).  Uh-oh, again.  Ginnie provides guarantees for mortgages associated with FHA, VA, and other government organizations.  Wait a minute, you say.  Aren't those FHA mortgages already backed by the government?  Well, yes.  But GNMA provided the vehicle for the bundling or pooling of these mortgages into securities (also called bonds).  GNMA guarantees those securities, which are traded like other bonds on the market.   Whew.

So what happened to poor Fannie, cast off by the government?  She started doing her own guaranteeing of securities and charging a fee for it.  Fannie was now called a GSE (Government-Sponsored Enterprise).   As a private corporation, Fannie no longer offered the security of a government-backed guarantee -- but most folks continued to think she did.  It was only natural to assume that government-sponsored meant government-guaranteed. 

We have not forgotten Freddie Mac. His full name is Federal Home Loan Mortgage Corporation.  Uh-oh again.  He was formed in 1970 to provide competition for Fannie in what had now become the secondary mortgage market.  I suppose that Congress, in its infinite wisdom, did not want to give a single GSE an unfair advantage.  They want all of us to be the same.  Besides, this bundling of mortgages into securities and selling guarantees that were really not worth much was really heating up and was very profitable.  People were buying homes and lenders were making loans they felt were fail-safe.  They felt so safe in fact; that they dropped customary lending practices and started making loans to anybody who could fog a mirror.  At twenty-four, I was not a great risk when I bought my first home, but I had to meet standard criteria (down-payment, income, good credit, etc) to get my loan. Even with an FHA guarantee.

Competition heated up between Fannie, Freddie, banks, mortgage companies, and brokers.  Everyone wanted in on the act.  Money flowed; greed controlled.  Mortgages were no longer personal transactions between a borrower and a lender; they were lumped together and became impersonal bonds -- bonds that investors loved.  They also loved owning stock in Fannie and Freddie. 

Recognizing a good thing when they saw it, Fannie and Freddie (now headed by CEOs who seemed to have extraordinary political connections or political positions on their resumes) branched out into derivatives.  Don't ask.  Ok, short answer is these are securities derived from the underlying pooled bonds.  Risk is higher.  I don't have enough space to explain more.  Lending went wild.  An almost new profession of mortgage broker had been created.  His job was to sell mortgages for a commission.  A lot of these brokers were fresh out of college and in their first jobs.  Most had little regard for whether these mortgages would be repaid.  After all, they would never hear from the lender or borrower again.  Commissions were good, executive bonuses went into the stratosphere.

The mortgages instantly left the lender on a fast train to see Fannie and Freddie, who instantly turned them into securities and put them on the market as bonds.   Stockbrokers sold the bonds and unwitting investors scooped them up.  Who noticed or cared when the occasional borrower defaulted? 

So, how does Congress correct this mess?  Who pays for the bad loans?  Congresspersons, most of whom think a derivative is an after-dinner drink, blame everybody but themselves.  Democrats almost wholly blame predatory lenders and greedy brokers, citing the need for more regulation.  How about another sibling for Fannie, Freddie and Ginnie?  Others, including some Republicans, blame greedy buyers who bought houses they could not afford in order to "flip" them when prices continued their never-ending climb.  Well, prices did not continue their climb. 

As for me, I blame them all.  But most of all, I blame Congress.  They created this mess of bureaucratic organizations.  They are guilty on multiple counts.  With the worthwhile intention of making it easier for people to own their own homes, they interfered in the markets and unwittingly encouraged greed, poor business practices, and the creation of weak securities.  Most of all, they discouraged acceptance of personal responsibility for one's acts.  A chicken in every pot, a car in every garage (a two or three car garage, by the way), a home you can't afford.  Elected Senators and Representatives have a time horizon that does not extend past the next election.  Some have a horizon only as far as cocktail hour.  They do not understand the law of unintended consequences. 

Congress and the Federal Reserve have unrelentingly kept up a steady march to make mortgages available to everyone.  From the Community Reinvestment Act of 1977, which encouraged faulty lending practices (demanded them), to the formation of GSE's, to the encouragement of interest rates below what the market should allow, to indirect and direct subsidies to GSE's, the government, in all of its machinations, caused this crisis.  Now, they are rewarding this bad behavior by bailing out irresponsible lenders and borrowers.   Have you noticed the new commercials for mortgages?  Bad credit, not to worry.  Reward bad behavior and you get more of it.  You and I pay the price. 

Jim H. Ainsworth a former CPA, CFP, CLU, Registered Investment Advisor, Licensed Securities Principal, was twice named one of the most influential accountants in America by Accounting Today magazine.  He is the author of eight books and hundreds of articles.  He has also ridden horseback across Texas.