[Home][Banking][Community Development][Newsroom][Education Resources][Publications][About Us][Research]
Home > Publications > Central Banker > Winter 2008 > How Will Fannie and Freddie Operate in the Future?

Central Banker | Winter 2008

How Will Fannie and Freddie Operate in the Future?

The U.S. mortgage market has gone through enormous change during the past few years. Fannie Mae and Freddie Mac, two giant government-sponsored enterprises (GSEs), have been at the center of much of this upheaval. Today, Fannie and Freddie are in an unprecedented and paradoxical position. They dominate mortgage lending to an extent never seen before, yet the firms themselves lie in financial ruin. How will Fannie and Freddie operate in the future?

Fannie, Freddie and the financial crisis. Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Loan Corp.) dominated the mortgage market early in the decade, with almost $2.5 trillion of mortgages underwritten to their credit standards—so-called prime conventional/conforming mortgages—during the peak year of 2003. This accounted for 62 percent of all mortgage loans made that year. The surge since early 2007 occurred because other mortgage lenders were contracting or exiting the market altogether. Moreover, Congress increased the loan amounts that Fannie and Freddie could purchase—that is, the conforming-loan limit was raised, creating the new category of "conforming jumbo loans."

Despite their commanding market presence, Fannie Mae and Freddie Mac collapsed into government conservatorship on Sept. 7, 2008, a form of suspended animation in which holders of the GSEs’ common and preferred stock were virtually wiped out. But the mortgage operations continued uninterrupted, and all the debt and mortgage-backed securities that the firms issued were guaranteed by the federal government.

How did we get here? Despite many advantages, including an expectation by many market participants that the federal government would not let them fail, Fannie and Freddie badly misjudged the risks involved in mortgage lending. The GSEs and many other mortgage lenders essentially (and foolishly) had assumed that house prices could not decline significantly across the entire country at the same time. Once this began to happen after 2006, the rate of default and the losses lenders suffered on each default began to increase sharply. The initial spike in defaults appeared in subprime mortgages, but, by mid-2008, it had become clear that near-prime and even prime mortgage portfolios were suffering loss rates many times higher than previously expected. Because they held so little capital against unexpected losses, Fannie and Freddie—by far the largest mortgage funders and guarantors in the market—had became insolvent.

The future of Fannie and Freddie. Many people are asking how Fannie and Freddie will operate in the future. No one really knows because the fates of Fannie and Freddie lie with a future Congress. Federal lawmakers must decide whether, and how, to rehabilitate and reform the GSEs.

There are at least four distinct options under consideration. Will we go back to the traditional GSE model, in which the federal government provided numerous financial and competitive advantages to the firms while private shareholders provided equity capital and expected competitive returns on their stock? Will we, instead, liquidate the GSEs’ operations and allow the private sector to fill the void created by the disappearance of Fannie and Freddie? Or will we effectively nationalize the former GSEs, operating them much like the Federal Housing Administration (FHA) and Ginnie Mae? Or will the GSEs’ huge portfolios be carved up into many small mortgage lenders that are privatized separately with no federal-government preferences or guarantees?

The ultimate decisions on Fannie’s and Freddie’s fates are sure to be hard-fought politically. Whatever political choices are made, the technical and legal obstacles to a smooth transition likely will be formidable. Yet, the future of mortgage lending in the United States depends critically on how the fates of Fannie and Freddie are resolved.

<< back to top