Sunday, September 22, 2019

Fannie Mae and Freddie Mac Reorganization

         President Trump has just announced plans to seek substantial reorganization of the Federal National Mortgage Association (FNMA) and known commonly as Fannie Mae, and the Federal Home Loan Mortgage Corporation and known commonly as Freddie Mac, the two main government sponsored entities that provide the funds for nearly half of the residential mortgage loans in the United States.

          Fannie Mae was formed in 1938 during the Roosevelt Administration as a government agency to expand mortgage lending so as to encourage homeownership and home building.  Prior to its creation, most mortgage loans were short term with a balloon feature, as banks were mostly dependent on their own savings accounts to fund the home loans. Any long-term lending meant tying up capital, precluding new, potentially more lucrative, new home loans and with defaults as high as 25% in the 1930s. substantial risk

          Fannie Mae allowed banks to make long term, fixed rate mortgages without the commensurate tying up their capital (or default risk) by buying the mortgage loans from banks.  They created a secondary mortgage market wherein loans purchased by Fannie Mae would be sold as collateralized mortgage obligations or later as mortgage-backed securities (MBS) to investors.  This freed up the banks to make new loans and receive a fee for each loan originated and sold to Fannie Mae.  In addition, the loans sold by Fannie Mae were guaranteed by the full faith and credit of the United States making the loans less risky even if the underlying borrower stopped payment and the mortgage was foreclosed.

          In 1954, Fannie Mae was reorganized into a mixed ownership corporation, selling off common shares to the public while the federal government retained control through its ownership of Fannie Mae preferred shares.  Further changes occurred in 1968 when Fannie Mae was converted into a fully private corporation, splitting the entity into Fannie Mae and the Government National Mortgage Association (commonly known as Ginnie Mae, which remained a government organization, and which insures certain mortgages such as loans by the Veteran’s Administration).  

          To increase competition in the secondary mortgage market (which Fannie Mae had controlled for thirty years), the government created a new government sponsored entity, Freddie Mac.  Freddie Mac was also a public company and also bought mortgage loans for sale on the secondary market. 
         
          The 1970s saw the steady rise of mortgage backed securities as the main vehicle of bundling of large blocks of mortgage loans.  The attractiveness of these MBS was due, in part, to the implied belief that the MBS was guaranteed by the United States, even though the entities were no longer owned by the government. 

          The 1990s and early 2000s saw the push towards expansion of the loan market to (i) increase home ownership, (ii) expand lending in areas that were previously avoided by lenders (known as redlining), and (iii) assist low to moderate income parties to obtain a mortgage loan.  This led to loosening of credit standards to meet these homeownership goals.  In addition, competition from private investment companies, who were also bundling more attractively priced mortgage backed securities, led to a more aggressive, riskier approach in lending approval by Fannie and Freddie

          This led to the subprime mortgage crisis in the mid to late 2000s with substantial defaults and failures of private investment firms and banks.  As of 2008, Fannie and Freddie owned one-half of the estimated 12 trillion-dollar mortgage market, and a true public collapse would have substantially damaged an already weak home loan market.  Instead, and as a result of mounting losses at Fannie and Freddie, the federal government placed both entities into conservatorship (essentially bankruptcy) to stabilize the housing market.

          After investing hundreds of billions of dollars into Freddie and Fannie, the institutions stabilized, and eventually became profitable, paying back the monies invested.  In fact, they have now repaid the full amount invested and a profit of nearly 110 billion dollars to the federal coffers.  

          Given this state of affairs, and the deregulatory mindset of the President, it is no surprise that he would propose modifying or even ending conservatorship.  The stated goal is to create a limited role for the federal government in the housing finance system, enhance taxpayer protections and increase the role of private sector competition.  This would be done by reducing the dividend paid to the federal government, allowing Fannie and Freddie to increase its capital reserve (now at only three billion dollars), a limited public offering and the long-term goal of total privatization.

          Given a divided Congress and the bad taste of 2008’s housing crisis, it appears that any materially changes may take years to settle.  In the meantime, low interest rates and high profits continue to benefit the federal government by holding onto Fannie and Freddie.

Michael J Posner, Esq., is a former Value Adjustment Board Commissioner, a board-certified real estate attorney and a partner in Ward Damon a mid-sized real estate and business oriented law firm with offices in Palm Beach County that handles purchase and refinance closing throughout South Florida. They can be reached at 561.594.1452, or at mjposner@warddamon.com

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