Tuesday, March 22, 2011


The connection between Finnie Mae, Ginnie Mae, and Freddie Mac and what different roles they played during the financial crises in 2008

Prepared by: Jonathan Kappler

Living the “American Dream” symbolizes for many Americans owning a house next to the dream of success, fame and wealth through thrift and hard work.[1] After the Great Depression and the stock market crash of 1929, this dream has been shattered. The US government responded to help the poor to live the American Dream again by creating federal and governmental institutions. Between 1938 and 1970 the US government created Finnie Mae, Ginnie Mae, and Freddie Mac. President Franklin D. Roosevelt laid the foundation of these institutions whose miserable financial standing is shocking the whole country nowadays.[2] The concept of these institutions failed seventy years later and contributed to the financial crisis in 2008. This paper will reveal the connection between these three institutions and what different roles they played during the financial crisis in 2008.


A historical background is necessary to show the connection between these three institutions. Under the “New-Deal” politics of President Roosevelt, the Federal National Mortgage Association (FNMA) was created in 1938 and later on known as Fannie Mae. The career of Fannie Mae started as a governmental organization which granted the institution access to governmental money by primarily purchasing FHA-insured mortgages from savings and loan associations (S&L’s) to encourage banks and loan originators to gain further access to capital for issuing more housing loans to borrowers. The simultaneously created secondary mortgage market was used to securitize these mortgages in the form of mortgage-backed-securities (MBS) and sell them to investors. Fannie Mae was set up as a government-sponsored enterprise (GSE), but the institution was converted into a public-traded company in 1968.[3] However, Fannie Mae didn’t lose their special status after they got privatized and could develop a lucrative business model. Fannie Mae was split in 1968 which lead to today´s Fannie Mae and to the creation of the Government National Mortgage Association (GNMA), also known as Ginnie Mae. The main idea of Ginnie Mae was to guarantee the payments of principle and interest payments on residential MBSs to institutional investors worldwide. These pools of mortgages were used as collateral to issue securities on Wall Street.[4] After the privatization of Fannie Mae, the successes of the institution lead to fear of a superior monopoly. For this reason the US Congress created another GSE in 1970, the Federal Home Loan Mortgage Corporation (FHLMC) which was better known as Freddie Mac. Freddie Mac was created to compete with the privatized Fannie Mae to avoid a monopoly. The government-sponsored enterprise specialized in expanding the secondary mortgage market by purchasing conventional mortgages, packing them up and selling the created MBSs to worldwide investors on the market.[5] Freddy Mac was acting similar to the concept of Fannie Mae.


However, the big competition between these two giants stayed away instead of that both of them were capturing the market in an enormous tempo. Fannie and Freddie cleverly used the difference between low capital costs and high profits yield from the mortgages. Alan Greenspan (FED) called this “the big, fat gap” later on.[6] Even if both organizations had the governmental order to boost residential properties they were quoted on the stock exchange and therefore became private corporations but with governmental financial protection. In 1999 Fannie Mae and Freddie Mac were pressured by the Clinton administration to expand mortgage loans to middle and lower income borrowers. That meant the organizations were compelled to lower the underwriting standards to create loans to subprime borrowers at higher interest rates than conventional loans.[7] When the Federal Reserve System (FED) under Alan Greenspan rapidly decreased the interest rate (federal funds rate) in 2001 to avoid a suspected regression, Fannie and Freddie mutated into an even more successful “money machine”.[8] The new cheap generated money was invested into the residential real estate market. The pressure on banks and loan originators to stay in business increased due to granting residential loans with too low interest rates. In Fannie and Freddie, the loan originators found purchasers of their residential home loans. Thus, the banks and loan originators expanded residential home loans which on the one hand resulted in an increasing demand and on the other hand in increasing prices of homes. Due to the overvalued prices of the homes, a resulting financial bubble was created.[9]


During the subprime mortgage crisis many bad collateralized residential home loans were circulating in the market. This was caused by granting loans to residential mortgage borrowers who didn’t qualify for standard prime mortgages.[10] At that time Fannie and Freddie were holding or guaranteeing $5.2 trillion of all U.S. home mortgages which were almost the half of the total outstanding mortgages, as can be seen on the graph.[11] Comparing this number to 1971 when it was 6% reflects the enormous growth in the last few decades of these both organizations. After the FED under Alan Greenspan raised the interest rate continuously from 2004 to 2006, the housing prices dropped dramatically. When the overvalued prices of the houses fell, the majority of the borrowers were unable to pay their monthly installments anymore.[12] Fannie and Freddie suffered under the inability of paying installments of once solvent borrowers which caused a big damage to these organizations. The result of this scenario was losses in billions for Fannie Mae and Freddie Mac in 2007. The damage was so huge that US-analyst assumed illiquidity of the organizations. The graph below demonstrates the impact of losses on their stock prices.[13] However, a bankruptcy of Fannie and Freddie would have lead to extensive follow-ups for the US economy and the rest of the world.[14] According to the phrase “too big to fail”, the US-Congress announced to respond by granting governmental loans and purchases of stocks in billions to support the institutions thus, avoiding bankruptcy.[15] The Federal Housing Finance Agency (FHFA) took control of both organizations Fannie Mae and Freddie Mac in September 2008. The federal takeover of Fannie Mae and Freddie Mac has been described as “one of the most sweeping government interventions in private financial markets in decades” and one that "could turn into the biggest and costliest government bailout ever of private companies.”[16] The end of the story was that taxpayer’s money was used to inject new capital into Fannie Mae and Freddie Mac.

To sum up, the harmless sounding organizations Fannie and Freddie were of no use for the most American citizens before the financial crises. Fannie and Freddie were belonging to the biggest financial institutions in the world because they were holding or guaranteeing every second mortgage of privately owned homes in the United States at that time. Fannie Mae and Freddie Mac were playing a very important role and were contributing a big part to the financial crisis in 2008. However, due to the enormous size of the corporations and the fatal follow-ups involved in case of bankruptcy (too big to fail) the US Congress could not have been afforded this scenario. Fannie and Freddie issued together securities in the amount of approximately $5 trillion; comparing this number to the GDP of the US which is approximately $14 trillion represents the extent of their size.[17] The collapse of these institutions would not only have been a disaster for home owners but also for the US-economy and many other financial institutions worldwide. The case of bankruptcy would have activated a series of reactions on the global markets. Even if taxpayers were suffering under the federal takeover of Fannie and Freddie, bankruptcy would have caused a way greater disaster than the one that had already occurred. After seventy years Fannie Mae and Freddie Mac are back where they came from: under governmental care.


References:

[10]Hansz, Andrew J, and Diaz III, Julian. “Real Estate Analysis: Environments and Activities. Dubuque, Iowa: Kendall Hunt, 2010.

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