Fannie, Freddie, and the Feds

By now I'm sure everyone has heard that the feds have taken over the management of two of the most powerful financial institutions in the United States: the Federal National Mortgage Association (FNMA, or "Fannie Mae") and the Federal Home Loan Mortgage Corporation (FHLMC, or "Freddie Mac"). Outside of the banking and financial communities, however, the significance of this move and its ultimate effects on the American economy are poorly understood. The following will provide a very brief treatment of this topic.

First of all, the "federal" in Fannie's and Freddie's names got there simply because both organizations began as agencies of the federal government and were later "privatized" ( the reverse process is known as socialism, where a private enterprise is "nationalized" or "federalized"). Aside from the rules and regulations that every financial institution must live by, Fannie and Freddie enjoy no special positions as far as the feds are concerned. This is because both organizations are privately-held corporations, just like General Motors or the New York Times. They have their own executives and boards of directors which answer to stockholders from all walks of life. If Fannie and Freddie get into business troubles, it is because their business practices were troubled.

So why should the feds be concerned with what happens to a private corporation?

Here's one very good reason: between themselves Fannie and Freddie are either guaranteeing, or own outright, about half of the 12 trillion dollars currently tied up in the housing mortgage industry! How they wound up in this position will require a short, and overly simplified, explanation.

Let's say that Local Community Bank has, after meeting all the appropriate federal and state regulations regarding cash on hand and other such matters, $1 million that it can lend to prospective home buyers. The homes are purchased (say 5 homes homes at $200 thousand each) with loans from Community Bank that are secured by mortgages of $200 thousand on each home, plus an annual interest payment of some percentage of the original loan value. So far, everyone is happy: 5 people have new homes and Community Bank is making a profit from the interest it is charging for making the loans.

The only problem is that Community Bank now has no additional money to lend to others wanting to buy a home. It must wait until either 1) it has more money available from its depositors or 2) it finds a way to convert the existing mortgages into more cash to lend to other buyers. Since waiting on its depositors to deposit more money would take time, the bank looks to convert its mortgages into cash by selling those mortgages to a third party. Enter Fannie and Freddie to make option 2 practical for everyone concerned.

Community Bank will negotiate the sale of its existing mortgages to Fannie and Freddie by agreeing to pay, to the latter entities, an interest late that is less than the rate it is currently charging the borrower. The bank now has another million dollars with which to make new loans plus it is making money on the difference between what it pays in interest to Fannie and Freddie and what it is charging the home owner. Fannie and Freddie get the money they use from either their own profits or by borrowing it from investors in the form of bonds, which pay an interest rate which is slightly less than the interest rate it charged when it purchased the mortgages from Community Bank. Everyone is still happy until something comes along to upset this nice, tidy arrangement.

The 'something" that came close to crashing the entire system was the recent economic downturn. The resulting decrease in demand for loans to purchase new or existing homes, coupled with rising default rates on home loans that had been made to borrowers that had taken on mortgages that they were only marginally capable of repaying, put more strain on the lending system than it was capable of withstanding Fannie and Freddie, along with a significant portion of the American economy, were in danger of simply disappearing.

To be sure, the feds have exacted a toll on both organizations as the price of their "assistance." Fannie and Freddie will be under the absolute control of an appointed federal conservator for the foreseeable future, and it is unlikely that they will survive as recognizable corporations after a few years have passed. How the stock and financial markets will react to these developments remains to be seen.

While the intervention of the federal government may seem to be yet another "abuse of power" to some observers, the serious dangers posed to the national economy would have made non-intervention the equivalent of economic suicide.