Shares in the mortgage giants Freddie Mac and Fannie Mae plunged this week after Senate Banking Committee Chairman Tim Johnson, D-S.D., and Sen. Mike Crapo, R-Idaho, announced their plan Tuesday to eliminate both government-sponsored enterprises (GSE).
Freddie Mac and Fannie Mae would be replaced with the Federal Mortgage Insurance Corporation (FMIC), modeled after the Federal Deposit Insurance Corporation (FDIC) which protects bank deposits. The FMIC would backstop private mortgage capital after it suffered losses of 10 percent. The bill would also require a minimum of 5 percent down from borrowers for lenders to quality for the protection. The full draft of the bill will be released within days with a committee vote scheduled within weeks. The bipartisan plan was developed with input from the Obama administration.
The 42 to 43 percent drop in Freddie Mac and Fannie Mae shares between Tuesday and Wednesday seemed to be caused by speculators who were bailing out on a long shot that shareholders of both companies would win a law suit working its way through the courts. The suit would deny taxpayers the return of the $187.5 billion used to bail out the two enterprises during the crash, plus $7 billion in profit. Instead the suit demands profit distribution to all the share holders which, according to the White House could reach an additional $181.5 billion over the next 10 years.
Although few want to see Freddie Mac and Fannie Mae reconstituted as they were before the real estate collapse, there is little chance that in this election year the bill will be voted on by the full Senate. Consumer groups will fight against any changes that could lessen access to mortgages, while the Republican controlled House wants even less government involvement in the mortgage market.
What are Freddie Mac and Fannie Mae?
In 1938, as part of President Franklin Delano Roosevelt’s New Deal, the Federal National Mortgage Association, nicknamed Fannie Mae, was created during the Great Depression. As the economy collapsed, borrowers defaulted on the home loans so banks found themselves cash poor. Fannie Mae bought up mortgages so that local banks could finance new home mortgages with federal money. Fannie Mae’s overt aim was to increase housing market liquidity.
Fannie Mae was instrumental in developing the secondary mortgage market. It could borrow at a low rate because of its government guarantees and pass the savings onto banks, which in turn passed low-interest, fixed-rate mortgages along to the homeowner. Low and middle-income mortgagors, who wouldn’t have qualified otherwise, were able to borrow for the first time to buy homes of their own. Fannie Mae increased the level of home ownership and the availability of affordable housing.
For its first thirty years, Fannie Mae practically had a monopoly on the secondary mortgage market. Then in 1968, with the federal budget strained by the Vietnam War, President Johnson took the company’s debts off the federal balance sheet and converted the company into one owned by private investors, but still backed by federal money, a peculiar hybrid termed a government sponsored entity. So that Fannie Mae wouldn’t be a monopoly, two year later, the Federal Home Loan Mortgage Corporation, Freddie Mac was launched. Both had access to a line of credit through the U.S. Treasury, state and local tax exemption, as well as exclusion from oversight by the Securities and Exchange Commission. The two entities became the primary guarantors of mortgages to homeowners in the U.S., buying mortgages the banks made, as long as the loans met strict size, credit and underwriting standards.
During the housing bubble, loan originators backed by Wall Street capital bypassed the two GSEs, peddling large numbers of high-risk subprime mortgages with predatory lending terms that dramatically increased the risk of default. The loans were securitized and snapped up by eager investors. As the bubble expanded, Freddie and Fannie lost market share, from about half of all home loans in 2002 to 30 percent in 2005 and 2006. That year, to win back market share they started investing in subprime securities that were rated low-risk, but soon proved not to be.
The bubble burst in 2006; the collapse in housing prices and increase in foreclosures led to huge losses for Fannie and Freddie. When the federal government took control of the two GSEs in September 2008, through a legal process called conservatorship, the government got preferred stock in the companies in return for what was initially $150 billion in bailout funds, with as much as $50 billion more to come as needed.
Through 2012, both Fannie and Freddie were paying the U.S. Treasury dividends on its stock. Starting in 2013, the government started collecting all of each firm’s profits. Investors who own the 20 percent of Fannie and Freddie not controlled by government, are the ones that have filed the aforementioned lawsuit that seeks to renege on the return of the bailout funds that saved both companies. Soon the stock price will stabilize, because Fannie and Freddie are still backing three out of five new mortgages in the U.S.