Tuesday, July 17, 2007

Government-Sponsored Enterprises: An Introduction to Fannie Mae and Freddie Mac

by Amy Lillard

We've all heard of Fannie Mae and Freddie Mac, in various tones and across different topics. But are they? How do they operate in the world of mortgages, money, and home ownership? How are they different from other banks and lenders? In a series of articles, we examine the good, the bad, and the curious about government-sponsored enterprises, otherwise known as Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac are the two government-sponsored enterprises (GSE) in a specific area of mortgage lending. The goal of these private companies is to help expand home ownership across the country.

In a roundabout way, they've helped millions of people obtain homes and mortgages over their years of private existence. They also offer direct loans of various types, lead a number of public initiatives designed to expand home ownership, and offer mortgage education for consumers.

Seems simple enough. But confusion reigns when it comes to these two companies. Why? Two reasons – their work within the "secondary mortgage market," and their complex relationship with the government.

Secondary Mortgage Market
The primary market is where most of us live, and what most of us consider when it comes to lending and mortgages. These are transactions directly between homebuyers and mortgage lenders, like banks, credit unions, state and local housing finance agencies, and other institutions. When places like banks lend money to borrowers in the primary mortgage market, they are either using funds from their own deposits, or funds from what’s known as the secondary mortgage market.

Banks and other institutions will often sell the loans they make. GSEs purchase mortgage loans from banks, bundling them together into tradable securities. These are then sold to large investors, like fund managers, foreign central banks, commercial banks, pension funds, insurance companies, other financial institutions. The idea is that lenders get more funds from selling their mortgages to the secondary mortgage market, allowing them to originate more mortgage loans and enable more home purchases.

The secondary mortgage market offers liquidity of mortgage funds, meaning mortgages can be offered quicker, with a more standard value despite economic conditions. This standardization attracts investors, adding further strength tot he mortgage market. Finally, the secondary market aims to make funds available to lenders nationwide, correcting some imbalances that might occur by region.

Because of their role in the secondary mortgage market, Fannie Mae and Freddie Mac are the largest source of housing finance in the country, according to their oversight organization, the U.S. Department of Housing and Urban Development (HUD).

Government Charter
Fannie Mae was founded in 1938 as part of President Roosevelt's New Deal policies, the first organization to establish the secondary mortgage market and an important step in easing Depression woes. The Federal National Mortgage Association (FNMA, or Fannie Mae) operated for years as a government entity. In 1968, the company became a fully private organization working in the secondary mortgage market. Freddie Mac, on the other hand, was chartered by the government as a private company from the start, with a mandate to work within the secondary mortgage market.

Now – why are they "government-sponsored enterprises" if they are fully private corporations?

Each company has a congressional charter requiring them to achieve public purposes, those described above in the secondary mortgage market section. In exchange for carrying out these purposes, the companies get some special privileges. They are exempt from state and local taxes, and get conditional access to a line of credit from the U.S. Treasury worth several billions.

Most investors in the secondary mortgage market assume, because of the government charter and special privileges given to the GSEs, that the securities offered by Fannie Mae and Freddie Mac are guaranteed by the government. In fact this is the not the case, and is the biggest misconception about the companies.

Understanding the secondary mortage market and government charters is a major step towards comprehending the importance of Fannie Mae and Freddie Mac. In our continuing series, we'll examine other aspects of these GSEs, including their initiatives to increase home ownership, their surprising scandals, and more details on their role in the housing market today.

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