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What Do Fannie Mae and Freddie Mac Do?

What Do Fannie Mae and Freddie Mac Do?

March 10, 2003

"What are Fannie Mae and Freddie Mac, and what do they do?"

Fannie Mae and Freddie Mac are "government-sponsored enterprises" (GSEs). This means that they are privately owned, but receive support from the Federal Government, and assume some public responsibilities.

The GSEs provide a secondary market in home mortgages, purchasing mortgages from the lenders who originate them. They hold some of these mortgages, and some are "securitized" -- sold in the form of securities which the GSEs guarantee.

The two GSEs today are among the largest corporations in the world.

What mortgages do the GSEs purchase?

"Conforming mortgages" as they are called consists of all home mortgages that meet the underwriting requirements of the agencies, and are no larger than the largest loan the GSEs are allowed by law to purchase. In 2003 the maximum was $322,700. It is raised every year in line with increases in home prices. The mortgages the GSEs can purchase account for roughly 80% of the conventional (non-FHA/VA) home loan market.

What kind of support do the GSEs receive from Government?

The major support consists of the credit lines with the US Treasury. This, along with their histories -- both were public institutions before they became privately owned -- mark them as having a special claim for Government assistance in the event they ever get into financial trouble. As a result, investors consider the notes they issue and the mortgage securities they guarantee almost as good as securities issued by the Federal Government itself.

Do the GSEs have competitors?

Not in the conforming loan market. Because of their Government backing, the GSEs can sell notes and securities at a lower yield than any strictly private secondary market firm. This gives them a monopoly -- or rather a duopoly, since there are two of them -- in the market in which they operate.

The GSEs do have emulators, however, in the non-conforming market. While the cast of players changes, at any one time there are usually 15 or more strictly private firms that purchase non-conforming loans and securitize them in much the same way as the GSEs.

"Why do two private firms receive Government support, while the others don�t?"

The Government did not select the two firms for special treatment. Both the GSEs began as Government entities, and the major objective in privatizing them (while retaining Government support) was to encourage development of a private secondary market. The other firms arose later, based on the GSE model, so that objective was achieved.

If the objective was achieved, why do the GSEs continue to receive special support?

The GSEs are unwilling to give it up, and they have become so powerful politically that they have managed to thwart the several attempts that have been made to take it away.

Do I have anything at stake in this issue?

If you are a potential borrower eligible for a conforming loan, your interest rate will probably be about 1/4% lower than it would be absent the GSEs. This reflects their relatively low funding costs, part of which is passed through to borrowers.

In addition, if you are a low or low-to-moderate income borrower, and/or reside in an underserved area, you might find a loan through a GSE. As part of their public responsibility, the GSEs commit to purchase specified numbers of such loans. How many would not be made without the GSEs, however, is not clear.

As a taxpayer, on the other hand, you have a cause for concern. The low borrowing costs of the GSEs is based on implicit Government backing for their $3+ trillion of debt and guarantees. If the GSEs ever have a financial disaster, the Government will have to bail them out and you and I will be on the hook for the cost.

"Is anybody regulating the GSEs to prevent such a disaster?"

A few years ago Congress gave that responsibility to the Department of Housing and Urban Development (HUD). Very few informed observers believe that HUD is up to the task.

"Is there a way to eliminate the risk of a financial disaster by removing Government support without hurting investors who rely on that support?"

It could be done by 1) revoking the credit line the GSEs now have with the Treasury, and b) providing an explicit Federal guarantee of all debt and GSE guarantees outstanding on the date the credit line is revoked. An explicit guarantee on the old claims would prevent any repercussions in the financial markets, yet put the markets on notice that news ones are not guaranteed. Over time, the volume of guaranteed claims would gradually decline.

Copyright Jack Guttentag 2003


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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