Freddie and Fannie: Living in the Past

by: Max Fraad Wolff

Shares plummet and pundits rage. Everyone has an opinion about the health and best future for the semi-governmental agencies designed to smooth attainment of the American Dream. It is sad that few have found the time or interest to explore the history, function, predicament of these pillars of middle class home ownership and international finance.

Fannie Mae (FNM) was created in the depths of the great depression to decrease foreclosure and increase homeownership. In 1968 it was re-chartered as a public company. Since its inception in 1970 [PDF file], Freddie Mac (FRE) has financed 50 million homes. As both enterprises' mission statements make clear, they exist to facilitate, ease and cheapen home ownership by acting as liaisons between international capital markets and those seeking to purchase private residences in the US. They borrow at preferential rates, based on the implicit/explicit assurance of the US government. Borrowed funds are used to buy mortgages and bundles of mortgages aimed at reducing the bank risk and buyer cost of home mortgages. These firms exist to facilitate, ease and accelerate bank lending for home purchase. Firms, central banks, investors and funds lend to get returns above the Treasuries that carry an explicit form of Uncle Sam's guarantee and lower yields.

Fannie and Freddie form a central hub in the relations between lenders and investors. This relationship is neither healthy nor sustainable in its present form. Uncertainty of direction and speed of deterioration are riling markets, regulators and anyone with the faintest understanding of what is at stake. As the Street and investors seek explicit assistance, one thing is sure. These firms will not be operating over the next few years as they have across the last decade.

Freddie and Fannie went into overdrive during the crazy phase of the recent housing bubble (2002-2007). Interest rates and credit standards tumbled. Homes were bid up to lunatic excess and these firms continued to do what they were chartered to do. They slurped up hundreds upon hundreds of billions of dollars from international capital markets and help direct world 'excess' savings into American home mortgage loans, bundles of home mortgage loans and bundles of bundles of mortgage loans. Home mortgage lending doubled between 2001 and 2008- an increase of $5.5 trillion.

Freddie and Fannie kept pace with the bubble by buying and backing mortgages, selling and packaging mortgages as they rolled in, wave after wave. Private firms entered the lucrative markets in growing scale across the boom years. Some of these firms specialized in mortgages that were too large, too poor in credit quality, too exotically structured or too low on documentation for Freddie and Fannie. Many of these loans went to the lower income folks Fannie and Freddie were supposed to be focused on. A solution was found, Fannie and Freddie bought some of the securities made up of these loans. I think you already know the rest of that story.

The size of the retained mortgage portfolios is truly gigantic. The extent of the firms' guarantee commitments is global in scope. 66 global central banks buy loans bundled and or backed with Freddie Mac and Fannie Mae involvement. As of June 30, 2007 Foreign entities and individuals held over $1.4trillion in US agency securities [PDF file]. Fannie Mae's June 2008 statement declares a gross mortgage portfolio of $750 billion and guarantees of mortgage backed securities and loans of $2.6 trillion. Freddie Mac's June 2008 [PDF file] statement details a retained portfolio balance of $792billions and a total mortgage portfolio balance of $2.2 trillion.

These two giants have retained interest in over $1.5 trillion and guaranteed over $4.5 trillion in mortgages, mortgage backed securities and loans. There are $11 trillion in outstanding mortgage liabilities in the US. The quality of retained loans, securities and guarantees is open to serious question. Present capital not with standing, there are serious valuation and long term credit quality issues.

What we are witnessing is the breakdown of the link between middle class America and the global financial markets it has over-tapped across the last several decades. The serious and persistent issues at Fannie and Freddie are only the most obvious example of a shift in the relationship between American families and international capital markets. The speed and size of the turning away from further lending to US real estate is astounding. Fannie and Freddie have been caught with weak financials, swollen balance sheets and escalating carnage. The housing market is and continues to melt down with dire consequence. In the 7 years from 2001 through 3Q2007, household real estate value increased by $8.873trillion to $22.495 trillion. It has since fallen by $426billion.

Those claiming a bottom, or even knowledge as to the timing of a bottom, should be viewed with extreme weariness. The search for parallels yields little. The closest one finds is the interesting decline in home ownership across the period 1905-1920 followed by a surging rise across the twenties and then collapse across the 1930s. Fannie was born of this collapse, the ideology of The New Deal and sense that government driven market interventions could broaden home ownership in America. This was a success. Home ownership did grow spectacularly across the period from 1938-2007. It is falling now.

In 1940 US home ownership stood just below 44%. At the start of 2008, following the largest decline in the history of home ownership record keeping, 68% of Americans owned their home. Over the decades, Fannie and Freddie changed, middle class America changed and the global financial realm underwent several revolutions.

The last and most transformative revolution involved the rise of securitization and integration of global financial markets. A world of wealth poured into US real estate. This flow was channeled and molded by the actions of Fannie Mae and Freddie Mac.

The decline of these firms will have dramatic and long lasting implications for home mortgage finance. Securitization will lag its recent levels for years, if it ever attains its 2006-2007 heights. Housing prices have further to fall and global savings will likely never be lent to American consumers at recent levels. The diminished role of these institutions risks combining with a virtual cessation of private activity. Policy makers and management at Fannie and Freddie are at a crossroads between modern realities, their missions and international financial realities. Many things have to give.

Disclosure: Long SKF and SRS.