Fannie and Freddie - Some Facts to Keep in Mind

Fannie (FNM) and Freddie’s (FRE) troubles have prompted this post (interrupting my work on the upcoming first installement of Build an Investment Bank). Basically, what I’ve bee hearing is that Freddie and Fannie are in trouble. Interesting. Here are some things to keep in mind about Fannie and Freddie…

1. Fannie and Freddie essentially securitize mortgage loans. This is complicated, but here’s the story in their own words:

Mortgage lenders … deliver pools of mortgage loans to us in exchange for Fannie Mae MBS backed by these loans. After receiving the loans … we place them in a trust that is established for the sole purpose of holding the loans separate and apart from our assets… Upon creation of the trust, we deliver to the lender (or its designee) Fannie Mae MBS that are backed by the pool of mortgage loans in the trust and that represent a beneficial ownership interest in each of the loans. We guarantee to each MBS trust that we will supplement amounts received by the MBS trust as required to permit timely payment of principal and interest on the related Fannie Mae MBS. We retain a portion of the interest payment as the fee for providing our guaranty. Then, on behalf of the trust, we make monthly distributions to the Fannie Mae MBS certificateholders from the principal and interest payments and other collections on the underlying mortgage loans.

(emphasis mine)

The essential point here is that Fannie and Freddie take on the entire risk of the mortgage defaulting in exchange for an ongoing fee (generally 50 bps per annum). The fee they charge for this type of transaction is small, generally less than 1/2 of 1/32nd of one percent of the principal balance of the loans they are guarenteeing.

Also, Fannie and Freddie retain any risk of hedging their exposure. Part of this is meant to imply that the fees they collect offset the losses they expect to endure, but there’s also a lot of expense to hedging these exposures. I won’t pretend to understand all the complexities of this process, but they have to manage duration risk and interest rate risk (note that in mortgages, these are linked, but not exactly the same thing: lots of factors, including interest rates, affect a borrower’s decision to prepay their mortgage and changes in interest rates affect the future cashflows from fees).

This is more art than science as it is very dependent on odd accounting rules and complex models–models that are a best guess at an uncertain future. Read their risk management section (and keep in mind that O.A.S. models are just lots of iterations run over another set of models… so, two layers of models… and we know how good those have performed) or this OFHEO report, specifically the sections on risk (Model Risk especially). The report I just linked to goes into, in depth, the various risk, accounting, and hedging issues at “the Enterprises.”

2. Fannie and Freddie are one of the largest, if not the largest, buyers of mortgage product. They buy their own mortgages (ones they have seen securitized) and hedge their massive portfolios. They issue bonds at extremely cheap levels to fund these activities. One former treasury official seems to think that this huge funding advantage seems to have translated into a bit of reckless purchasing on the part of the agencies. They even tout this–going back to the Fannie filings, we learn the following:

The U.S. Congress chartered Fannie Mae and certain other GSEs to help ensure stability and liquidity within the secondary mortgage market. In addition, we believe our activities and those of other GSEs help lower the costs of borrowing in the mortgage market, which makes housing more affordable and increases homeownership, especially for low- to moderate-income families.

(emphasis mine)

How noble! They lower the cost of a morgtgage by, well, buying lots of them and lowering rates. Why do they buy so much? so they can lower rates. Easy to understand, right? The reason they do this is to help increase home ownership. Interesting, then, that their business volume in 2007 had 11% investor properties or second/vacation home (see table 41, here).

Also interesting, then, that 32% of their business was lending for cash-out refinancings (same table)–those don’t seem to be helping home ownership, and actually reflect a higher risk segment of mortgage loans. So, Fannie and Freddie own a huge amount of their own product, which is notoriously difficult to hedge, have bought a lot of product fore the sake of buying, and seem to have a portfolio composition that is slightly different from it’s purpose… Well, holdon. It gets even better!

3. Fannie and Freddie were the largest buyers of sub-prime mortgage bonds and commercial mortgage-backed securities. Look at any securitization, look at the AAA-rated portions, and if there is a class that is all loans considered “conforming balance” or have amounts that generally conform to the agencies’ maximum loan size limits, then you know those were purchased by an agency. At the end of 2007 Freddie owned $100 billion of these sub-prime securities (according to OFHEO, page 43, pdf) where 21% of loans were 60+ days delinquent. Fannie Mae has about 13% of it’s portfolio, which was an average of $725 billion during 2007 (from their filings), or $94 billion.

Now, if regulators understood these products, they would understand that securitizations are structured in a way that Fannie and Freddie could be at risk for a decline in value of their own securities that occurs from the performance of the other assets–the ones that have nothing to do with their goals and charter. I would even challenge anyone who thinks that congress would agree with the programs that Fannie and Freddie use to support their mission … I’ve been on calls with people discussing how Fannie and Freddie merely need to be able to claim something passed the most cursory of tests to take on a $1+ billion loan. Providing the opportunity to afford housing to credit worthy indivisuals has nothing to do with buying CMBS and sub-prime RMBS.

What does all this point to? Seemingly a massive amount of “mission creep” for the agencies that lead them to be over-levered, in increasingly risky products, and in an accounting and hedging nightmare.

Comments

[bbzz24]

any ideas what we can expect from those entities? it seems that their 'business model' has just crashed and burned.

[jjason]

After I read the word "complicated"... twice, I scrolled down ( seeing the words "risky,and then NIGHTMARE" ) and I am thankful that I never bought common stock in these two firms. I also avoided Bear Sterns and all the other I banks because they are all complicit in the disaster that has been unfolding. Whoever gets to be President will HAVE TO RAISE TAXES to pay for any GOVERNMENT BAILOUT.

Or, the Treasury Secretary could print more money and give it away.

The citizens of the United States who are honest have been taken advantage of by the business "leaders" and government "regulators" and members of the Congress, George Bush and the administration who did nothing to prevent this from happening.

[xsuddensam]

Amen, jjason!

Throughout this financial crisis, the Fed, Paulson, the pundits and commentators like Crammer, Kudlow, Kernen and the rest of the CNBC jerks rarely mention the words FRAUD or JAIL.

There has been a massive fraud perpetrated on the American people and the perpetrators who made tons of money will go free to enjoy it. It seems to be the American way.

[jlounsbury59]

I keep reading 100+ to 1 leverage for FNM and FRE. Just how much of that leverage can be hedged? If asset values mortgaged fall below the outstanding balances total for all mortgages, the balance sheet is negative. This could happen. This crisis is making mortgages harder to get. Therefore demand for houses goes down. Econ 101 teaches that falling demand produces lower prices. Lower prices tighten the credit market further. Still lower demand results. This is a death spiral.

Ponzi scheme anyone?

[truthinvesting]

My worldwide forum has followed this. One idea floated is that government and privatesector will be buyinga prefrered stock which will stabilize the company but the common shareholders will never get much back

[HowlingMad]

The US government needs to get out of business period. While the allure of morgages for the average American is a noble cause the execution of such is seriously lacking, like any other government 'anointed' bureaucracy.

If you read the last House Appropriations Bill like I did you would realize just how screwed up our government is. (Yes, I read all 3500 pages).

Did you know the gov't spends interesting amounts of money like:
2.1 Billion dollars to cover mortgage companies losses (only for farms though). This was enacted Jan 2006.

The DOJ spends 539 million a year in rent. To whom? The office of Building Management in Washington, DC.

I just love how the IRS spent 142 Million to notify you of your stimulus check while the broadcast media did a quicker and better job for FREE!

I would only support a bailout of Freddie and Fannie if it is a LOAN payable within 5 years. This would stop F&F from living in the lap of luxury and start holding them accountable. (If you were ever to their offices you would know what I am referring to)

[Rawbhurt]

Does anybody have a opinion on AMBAC AND MBIA.
Cause there shares got a masive beating,so can these guys servive in the long run.

[Emdeplam]

Why am I always being robbed by my government to bailout others? I wish I was getting bailouts, dividends predicated on false accounting, bonuses based on fiction etc...

This is one big discussion about who gets to bend me over first!

[secmaven]

Freddie and Fannie provide approximately one half of the mortgage money in the United States. We can do without Indymac but if Fred and Fan stop lending nobody, but nobody will be able to buy a house with borrowed money. Guess what that will do to housing prices and the economy. Ben has told Fred and Fan that the discount window is open so they can keep this merry go round moving.

[E Nuff Sed]

Re: Rawberts comment - MBIA and AMBAC are part of the problem. Since F&F as part of the mortgages can only deal with prime mortgages with less than 70% loan (30% principal) it depends on the insurers to gaurantee mortgages with higher loan amounts i.e. the insurers like MBIA would have to gaurantee 20% of a 90% mortgage. Since the insurers have been downgraded, such mortgages (in CDO') held by F&F and other entities are also been down graded.

If the housing market recovers and actual losses don't materialize then all will be OK and the mark to market losses will be reversed. If housing market continues to go south and losses materialize then all these entities will go to hell in a hand basket -- esp the monolines like Ambac and MBIA.

[X-terminator]

Anyone and everyperson that understands what is going on with all this mess, should vote out every single legislator both congress and senator of their state. Are you kidding me? This and both presidential canidates are a complete joke. Wake up America before OH, and it may be too late!

[Did U ThinkThe PonziSchemeWould Last?]

It is a LIE to say that nobody will be able to own a home without fannie and freddie. The price of homes will come down. You will save for 10 years and you will buy one. In fact it will be easier to buy a home without the usury that is happening. The price of homes is WAY too high and the cheap and easy money system, which the FNM and FRE guarantees are part of, MUST GO AWAY. Do you really think that people who like to build homes for a living will not find a way to sell them? Gawd, get some faith in the free market system and cast away the notion that the only way things will work is if some greedy gov't sponsored financial scam is involved.

[Jerbear]

X-terminator, You are 100% correct. Our lazy Congress is at fault. They blame each other for getting nothing done and both laugh at the average american for believing them. The money they spend on pork projects could have gone to alternative energy research.

They collect huge paychecks, enourmous pensions and work very few hours. They live the life of a rockstar.

The two party system is a farse. It needs to be flushed.

Never-never-never vote for an incumbent.