Unless you live under a rock you are probably very familiar with the turmoil ongoing in the financial sector of our economy. This turmoil brought Indymac Bank to its knees last Friday when the Federal Government seized it’s assets for failing to maintain adequate capitalization. This bank failure is the 2nd largest bank failure in US history. Their failure has brought increased concern over the financial well-being of mortgage industry titans FNMA (Fannie Mae) & FHLMC (Freddie Mac).
Most people have heard of Fannie Mae and Freddie Mac but may not understand much about them. The media has recently done a great job of generating fear and panic surrounding these two companies but has yet to explain the crucial roles that these two entities play in our economy. It is my objective with this blog posting to clear some of this up and answer the following questions:
- Who are Fannie Mae & Freddie Mac?
- What exactly do they do?
- Why are they so important?
- Why are they currently in the news?
- And what would be the implication of their financial failure?
- What’s next?
Who are Fannie Mae & Freddie Mac? and What exactly do they do?……A Brief History
To first understand who Fannie & Freddie are let’s take a look at why they exist. Prior to these two entities (before 1938) the mortgage industry was fairly simple. A local or regional bank would collect money from individuals and businesses in the form of deposits and lend that money back out in the form of mortgages (or other types of loans).
This system worked pretty well for many years except for a couple limitations.
One problem with this system was that a bank was limited to lending out only a portion of the deposits they took in. Therefore, if a bank had $10 million in deposits they would have the ability to lend out only portion of those assets (say $9 million or 90% for example) depending on the prevailing reserve requirements. A reserve requirement is the minimum amount of deposits a bank must hold relative to the loans outstanding.
A second problem was that banks were typically limited to lending in the local area in which they were located.
Then came the national banks. These larger institutions had branch presence across the country. This gave them the ability to collect $10 million of deposits in New York City and redistribute these funds in the form of loans in another state (Illinois for example).
This system also worked fairly well for a number of years except during times of economic contraction when bank runs would occur. A bank run is when a large number of individuals withdraw their deposits from a bank for fear that the bank is going to fail.
This happened frequently during the Great Depression and stock market crash of 1929. The result was that when the economy needed monetary infusions to help boost growth the opposite would occur because banks would suffer huge declines in their reserves.
To rectify this problem, Franklin D. Roosevelt founded the Federal National Mortgage Association (Fannie Mae) in 1938 as a government agency. This agency was to provide liquidity in the mortgage market by buying mortgages from banks which they then chopped up and securitized into mortgage-backed bonds (avid ‘rate update’ followers should know what these are) that were sold to investors.
From a banks perspective, they were now able to lend a borrower an amount of money for a mortgage, sell the mortgage to Fannie Mae (and book a small profit), then lend that same amount of money again, and again, and again. Conceivably, as long as investors were willing to buy the bond backed by the original mortgage there was an endless supply of liquidity available for mortgage lenders. With this financial invention “securitization” was born and the period of credit expansion in the US was underway.
Add Freddie Mac
In 1968 the Federal Government decided that they no longer wanted Fannie Mae on their Federal balance sheet so they privatised the company. So that Fannie Mae would not act as a monopoly they also chartered the Federal National Mortgage Association (Freddie Mac) to compete with them.
To this day both companies are in existence as publicly traded entities and continue to provide liquidity to the mortgage market through the same purchase & securitization process described above.
Why are they so important?
Virtually every bank and lender out there is running at or near the minimum reserve requirement ratio which is currently set at 3% (simply put). Therefore, if a bank has $100 billion in loans outstanding, they have to have at least $3 billion in capital as backing (the reason Indymac failed last Friday was because they fell below this 3% level).
What Fannie Mae & Freddie Mac allow banks to do is to continue to lend even if they are getting close to their reserve requirements because as soon as they lend the money on a mortgage (increasing their loans outstanding and decreasing their capital), they get the cash back from the sale of the mortgage (decreasing their loans outstanding and increasing their capital).
Why are they in the news?
Fannie Mae & Freddie Mac are currently in the news because they are experiencing financial difficulty.
The current problems at Fannie Mae & Freddie Mac are twofold.
First, their loan portfolios have gotten very large which has raised questions about their solvency. In fact, today, Fannie Mae boasts a loan portfolio of $5.3 trillion. However, they only have $84 billion in capital which means their reserves are only about 1.58% of their outstanding loans. If they were a bank then the Federal Government would have already shut them down.
Second, they are losing A LOT of money which is putting further pressure on their capitalization ratio. These companies lose money when mortgages perform poorly because they guarantee the principal and interest on the mortgage-backed securities that they issue even if the borrower defaults. Therefore, during periods of rising defaults, delinquencies, and foreclosures-as is currently the case- these companies incur huge losses. In fact, according to their last two quarterly reports, they’ve lost over $11 billion in operating income over the last 6 months. These large losses coupled with their already low capitalization rate has investors concerned over their long-term viability.
What would the failure of Fannie & Freddie mean to the mortgage market?
The bottom line is that such a failure would be devastating to the mortgage market. The void that the loss of these two institutions would create in terms of providing liquidity in the mortgage market would be irreplaceable by the private sector.
In the event that these two corporations failed at best we could count on mortgage offerings that mirror the “non-conforming” or “jumbo” mortgage market today. These are loans that are portfolioed or securitized by the private sector and typically have much more stringent qualifying guidelines & (say good-bye to low down payment and investor loans) higher interest rates (currently non-conforming fixed rates carry rates in the 7-8.5% range.
At worst, mortgage lending would seize to exist except for seller contracts and private “hard money” loans.
The fate of Fannie Mae and Freddie Mac will likely be impacted on the health of the housing market & the Federal Government’s willingness to step in if need be.
Should we begin to see some stabilization in housing it would create incentive for borrowers to make their payments which would prevent foreclosures that cost these corporations billions. This could eventually allow Fannie Mae & Freddie Mac to return to profitability and hopefully rebuild their battered balance sheets.
However, should these two titans fail we believe the Federal Government will step in and nationalize these two entities to avoid an all out halt of mortgage lending in our economy. Of course, the longer-term problem with that is how the American taxpayer will pay for it.