Fannie Mae and Freddie Mac - Pervasive Impact on the Real Estate and Mortgage Industry

Michael Roche
March 22, 2011 — 1,375 views  
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 From time to time the federal government "sponsors" enterprises.  Such an entity is appropriately called a "Government-Sponsored Enterprise". There are a substantial number of these types of entities.  Perhaps none has had greater impact on the social fabric of American society than two mortgage related Government-Sponsored Enterprises, the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).  Each of these organizations has a homespun nickname, which are loosely derived from their acronyms.  In the case of FNMA, the nickname is Fannie Mae.  The nickname for FHLMC is more abstract, since it is derived from the "Federal" and "MC" in its acronym, and is referred to as Freddie Mac.

 FNMA, or Fannie Mae, was created during the Roosevelt era in 1938 to combat the effects of the "Great Depression", and was privatized in 1968.  FHLMC, or Freddie Mac, was created by Congressional action in 1970 to compete with Fannie Mae.  Each of these corporations is publicly traded, and therefore, is owned by their shareholders.  Their special status, however, permits them to enjoy very substantial advantages over any other publicly traded company. Even though investment in either of them is not government secured, investor confidence is very high because of the quasi-government association.

 Each of these organizations plays a huge role in the home mortgage arena.  The influence is so significant because of the function they perform.  Simple in design, but complex in execution, their market functions were and are to provide a conduit through which mortgages can be bought and sold.  Fannie Mae and Freddie Mac purchase home mortgages from banks and brokerage firms that provide loans directly to consumers.  Periodically, they bundle the loans that they have purchased into bond like securities and sell them to large institutional investors, such as pension funds, that are fond of stable investments that yield steady income.  The difference between the interest rate which the consumer pays, and the yield on the investment as it is sold, is how Fannie Mae and Freddie Mac make their money.  The profit from such transactions can be very significant, because the bundled sales often top $500,000,000 per transaction.

 As an aside, a home buyer should not mistakenly conclude that the interest rate which they pay on a mortgage loan is based on these transactions alone.  The original lending institution has taken a profit, the loan officer has taken a profit, and eventually the entity that will service the loan throughout its life will take a profit. Together these are the micro costs related to loans, which ultimately the consumer must pay.  The macro costs will be discussed later in this article.

 Together Fannie Mae and Freddie Mac form the most significant marketplace for mortgage loans.  Since they are stock companies, and thusly, have a responsibility to make money for their stockholders, obviously they would like to buy loans that provide a reasonable certainty of profitability. What that translates into at the ground floor is that the person to whom the mortgage loan has been made will make the loan payments on time and keep the loan to maturity.  Not surprisingly then, both Fannie Mae and Freddie Mac have set certain parameters for the types of loans they will buy.  These standards conform to statistics that they have compiled about the kinds of loans and the consumer profiles that will produce the desired outcomes, i.e., loans that are paid back on time and held to maturity.  What that translates to at the consumer level is that loans and home buyers that fit the profiles are the ones offered the very best loan terms and interest rates.  Those who do not "fit" are charged a premium for the loan.

 Lenders, who typically are very concerned about the resale of any loan they approve, are heavily influenced by the Fannie Mae and Freddie Mac standards for two primary reasons.  First, they are the leading purchasers of home mortgages in the secondary market.  Second, the parameters that they set have been adopted into the technology of the loan approval process.  Consequently, the loan policies that are set by Fannie Mae and Freddie Mac become the de facto loan policies of the vast majority of lending institutions.

 The underlying concepts on which these entities were created are good ones.  The federal public policy actions by Congress to create Fannie Mae and Freddie Mac serve the function of providing a means for lending institutions to sell the loans they have made and presumably use that money to approve more loans.  This sales function should make more home purchase opportunities available to more consumers, especially in low income areas.  Unfortunately, macro economics rears its head to influence the fluidity of the concepts.  Institutional investors that buy Fannie Mae and Freddie Mac bundled securities are influenced by the general economy as reflected in stock and bond markets performance.  Furthermore, the value of the bundled securities is influenced by borrower performance.  For example, if the ability of borrowers to repay their loans is affected by the performance of the general economy, i.e. if the number of foreclosures increases the value of the bundled securities become less attractive to investors. 

 Then there is the interrelationship between interest rates and home sales.  Lower interest rates stimulate home purchases, and vice versa, higher interest rates slow home purchases.  Each of these circumstances triggers the classic economic struggle between supply, demand and pricing, and the cyclical storm it creates.  In other words, when more homes are available in the marketplace, prices should drop and so should interest rates. 

 No matter what your conclusions may be, there is no question about the enormous influence Fannie Mae and Freddie Mac have on the terms and interest rate of the loan you obtain as a consumer.  Knowing the standards set by these organizations is of critical importance as you think about a home purchase

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Michael Roche