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Bailing Out Fannie and Freddie

How do the bailouts of the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association affect us?

by
Arnold Kling

Bio

July 15, 2008 - 12:11 am
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I used to work at Freddie Mac (Federal Home Loan Mortgage Corporation), in the late 1980s and early 1990s. These days, I like to joke that when I worked there, nobody had ever heard of them, because the place ran so smoothly that they were never in the news.

Recently, Freddie Mac and its big sister, Fannie Mae (Federal National Mortgage Association), have been in the news too much. On Sunday, U.S. Treasury Secretary Henry Paulson issued a statement that his agency, along with the Federal Reserve Board and other agencies, had developed a plan for “maintaining confidence” in the two government-sponsored enterprises (GSEs). The plan includes enhanced backing of GSE debt as well as an unusual provision to allow the Treasury to purchase shares of stock in the two companies.

What is the purpose of the Fannie Mae and Freddie Mac? How did they get into trouble? Will the new plan work? As ordinary homeowners and taxpayers, what should we think about the latest developments?

Fannie Mae and Freddie Mac are known as government-sponsored enterprises (GSEs) because they were created by the government and have enjoyed special regulatory privileges. However, they are both privately owned, with shares traded on the New York Stock Exchange.

Fannie Mae was created during the Depression, as an institution that would purchase mortgage loans. At the time, many regional banks failed, and Fannie Mae was like a giant national bank specializing in home mortgages.

Freddie Mac was created in 1970, to address a different problem. California was chronically short of mortgage money, and other states’ lending institutions had excess capital but were precluded by law from lending across state lines. Freddie Mac was chartered to create a “secondary mortgage market,” which would allow a mortgage lender in one state to purchase securities backed by mortgages originated by other lenders in other states. To do so, Freddie Mac guaranteed repayment of the loans.

Neither Freddie Mac nor Fannie Mae originates mortgage loans. As a home buyer, you will never deal directly with a GSE to obtain a loan. Instead, the GSEs buy mortgage loans that are originated by other firms, including banks and mortgage bankers.

As of the late 1970s, most of the mortgage credit in the United States was supplied by savings and loan associations (S&Ls), which are very similar to banks. However, the inflation of the 1970′s wreaked havoc on the highly-regulated S&L industry, leading to its collapse. Fannie Mae and Freddie Mac, with strong encouragement from Congress, stepped in to take mortgage assets off the balance sheets of the S&Ls for a fee. In effect, the GSEs fed off of the carcasses of the S&Ls, and subsequently the GSEs took over the role of being the chief providers of home mortgage credit in the U.S.

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