Fannie & Freddie - Part I

I've been wanting to do a bit of a write-up on the Fannie Mae/Freddie Mac debacle. There is a lot to this issue, so I am going to break this up into a series of posts. First, what do the companies do and why are they so important? Second, who are the winners and losers of the latest bailout? Third, what connections exist between the winners and the government? And fourth, my opinions on the whole situation.

Fannie/Freddie Overview:

Fannie Mae (the Federal National Mortgage Association) was established by the U.S. Government during the Franklin D. Roosevelt administration as part of the New Deal in 1938. Their stated goal is to "provide[s] stability, liquidity, and affordability to the nation's housing finance system under all economic conditions... [We] exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market." Freddie Mac (the Federal Home Loan Mortgage Corporation) was established in 1970, two years after Fannie Mae became a private corporation, to provide competition in the secondary mortgage market. Both companies enjoyed government sponsorship which came with specialized regulation, special access to funds, and the implicit backing of its risk by the Treasury.

The secondary mortgage market was established to help banks maintain liquidity (cash flow) so that they can continue to make housing loans. This allows people to more easily attain the "American Dream" of owning a house. Let's consider a simple example:

ABC Bank serves its local community. Let's say that 10,000 local customers deposit an average of $5,000 in savings with the bank. That gives ABC Bank $50M of bank deposits. In modern banking, a system known as fractional-reserve banking is universally accepted. In this system, banks do not have to keep this $50M on reserve. They can use this money to make loans and other investments. This is allowed since people deposit their money with the bank because they do not require immediate access to the funds. Banks use this opportunity to make money. In return, the depositors receive an interest rate on their savings. Let's say the interest rate paid by ABC Bank in this example is 4%.

ABC Bank now has $50M on hand. Let's say that they decide to always keep $10M on reserve for their customers who decide to make withdrawals. (Note: under U.S. banking regulations, banks are required to keep 10% on reserve for "transaction deposits" like checking accounts, and 0% reserve for "time deposits" like certificates of deposit.) With this $40M, ABC Bank works with local residents to provide mortgage loans. Let's say that ABC Bank provides 200 mortgages at $200,000 each. These are all 30-year fixed loans at 6.5% interest.

Now, every month, ABC Bank has to pay interest to its depositors. They also receive mortgage payments from their loan customers. A mortgage as described above would typically require a monthly payment of $1264.14. Using simple interest, the bank pays each of its depositors $16.67 each month. So, the bank receives $252,828, pays $166,700, and as a result increases its cash flow by $86,128 each month. This is a good business. But, at this rate it would take approximately 70 days for ABC Bank to increase its cash flow enough to loan out more money on additional mortgages. That also assumes that they reinvest all cash flow to additional investments leaving no money to pay the bills (including salaries) or give back to the owners and investors in the bank. This also means that residents in our community are limited in their ability to secure a loan to buy new houses. Enter Fannie Mae...

Fannie Mae offers to buy the debt associated to the mortgages from ABC Bank. So, ABC Bank packages the mortgages together and sells them to Fannie Mae. ABC Bank will receive cash from Fannie Mae which replenishes their cash flow. ABC Bank continues to collect the mortgage payment from its loan customers, but that money is passed on to Fannie Mae. Over the course of the 30 years of each loan, ABC Bank would have received $455,090 per loan for a total of just over $91M. However, the bank is willing to sell these mortgages as a package to Fannie Mae for far less than $91M because they'd rather have the money now so that they can conduct more loans. I have not been able to find exactly how much Fannie Mae would typically pay in such a scenario, but I would assume it is close to the net present value of the future cash flows. For the sake of argument, let's just say Fannie Mae pays ABC Bank $40M for the package of mortgages. Now, ABC Bank has $40M in fresh cash flow which can be used to make another 200 loans of $200,000 apiece available to the community. This cycle can continue as long as Fannie Mae has the money to buy the mortgages from ABC Bank.

So, where does Fannie Mae get its money from? A few different ways. First off, they make money on the process described above. As noted earlier, the total amount of repayment expected from one of the $200,000 loans above is over $450,000. By assuming the risk of the underlying mortgages and providing banks with much needed cash flow, Fannie Mae receives the benefit of the interest that homeowners pay. Generally, this is quite lucrative. Second, Fannie Mae repackages groups of mortgages which they have bought from banks all over the country and sells them as new financial securities call mortgage-backed securities or MBS. These MBS are bought by investors who seek a steady return on their investment; this includes many foreign central banks. Fannie Mae charges fees on these investments because they guarantee that payments will be made regardless of whether or not the underlying mortgages are being paid. In other words, they charge fees because they take on the risk. Finally, Fannie Mae has access to low interest government loans to raise capital.

As you can imagine, with the desire of banks to make money and for the government to see home ownership increase, Fannie Mae and Freddie Mac (they do the exact same thing as described above for Fannie Mae) have grown to be absolute behemoths. Between the two of them, they either own or guarantee about 40% of all mortgages in the U.S. Further, they are the key source of liquidity in the housing market allowing banks to keep making loans with fresh money. And that money comes from investors seeking stable returns such as Wall Street giants, foreign banks, mutual funds, and average investors.

When people start falling behind on their mortgage payments, it starts to throw a wrench in this massive cycle. Mortgage delinquency causes the payments which Fannie and Freddie rely upon to slow down. It should be noted that Fannie and Freddie's actions specifically do not cause delinquency. People lose their jobs, mismanage their money, enter into mortgages with variable interest rates, and buy houses that they can't afford in the long term. All of these factors can lead to delinquency. However, it should be noted that the business model of Fannie and Freddie exists to make it easier for banks to loan. The easier it is for banks to loan, the more risk they can be willing to take along with lower interest rates. This isn't the fault of Fannie and Freddie, but it is the nature of the system itself. They are just in the middle of it.

Going back to our example... if Fannie Mae repackaged the first set of mortgages and sold them as an MBS, they would need those monthly mortgage payments to flow in to ensure they can pay their investors. But, if there are delinquencies, then they have to make up the difference. This cuts into their ability to purchase other mortgages and their profitability. This is a big part of what has happened over the last couple of years which has led to the situation we are in now. They engaged in more and more risk, and some of that risk is beginning to rear its ugly head in the form of delinquencies and foreclosures. This reduces their cash flow as described above. Also, it makes investors less likely to want to purchase MBS. So, Fannie and Freddie have had to pay a higher interest rate on the MBS which dilutes their own capital and profits. The reason the U.S. Treasury "had" to step in was because the fear became too great that these two companies would not be able to continue to buy up more mortgages and pay their existing obligations. That means that a) investors would not get paid and b) banks would have much more trouble making loans.

In our next installment, we will look at the winners and losers of the bailout.