Monday, September 8, 2008

Freddie Mae and Fannie Mac: How did we get here?

To understand where you are you must first know where you started. So with the big announcement yesterday that the government will take over struggling Fannie Mae and Freddie Mac let’s review what these entities are and why they were created.

But first a statement from Treasury Secretary Henry Paulson: “Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance."

The Federal National Mortgage Association, nicknamed Fannie Mae, was created in 1938 as part of President Roosevelt's New Deal when private lenders were reluctant to invest in loans for homes. To encourage home ownership, Fannie Mae provided local banks with federal money to finance mortgages. Fannie Mae operated a lot like a national savings and loan, allowing local banks to charge low interest rates on mortgages. Because of the financial support that Fannie Mae received from the U.S. Government it was able to borrow money from foreign investors at low interest rates. This allowed Fannie Mae to provide fixed interest rate mortgages with low down payments to home buyers. Thus Fannie Mae profited from the difference between the interest rates homeowners paid and what foreign lenders charged. Fannie Mae also quickly became queen of the secondary mortgage market.

For thirty years Fannie Mae held a monopoly over the secondary mortgage market. Then 1968 changed things. Fiscal pressures created by the Vietnam War caused President Johnson to privatize Fannie Mae and remove it from the national budget. That’s when Fannie Mae became a GSE. A GSE, or government sponsored enterprise, is privately owned and operated by shareholders, but protected financially by the support of the Federal Government. These government protections include access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight. To further squelch Fannie Mae’s hold on the market, the Federal Home Mortgage Corporation, nicknamed Freddie Mac—another GSE was created in 1970.

The decades that followed were amazingly fruitful for Fannie and Freddie and it appeared that they would live happily ever after. Together they enjoyed total assets 45 percent greater than that of the nation's largest bank. But their debt also climbed to 46 percent of the current national debt. It is this combination of rapid growth and over leveraging that has lead to the current concerns of Congress, the Justice Department and the SEC with regards to the financial practices of these GSEs. Additionally accounting scandals have plagued Freddie Mac.
Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public of financial difficulties. If either should collapse, U.S. taxpayers could be held responsible for hundreds of billions of dollars in outstanding debts.

And that, friends, is how we got to the government takeover announced on Sunday. What will be the next piece of the story?

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