Did Fannie and Freddie Cause the Mortgage Crisis?

No, But Here's What Did

fannie and freddie

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Were Fannie Mae and Freddie Mac the real cause of the subprime mortgage crisis? It's dangerous to think so. That's because they were a prime example of the broader economic forces that caused the banking credit crisis and bailout. Legislative attempts to rapidly wind down Fannie and Freddie would not prevent another recession. Worse yet, it could devastate the housing market.

Role in the Mortgage Market

Fannie and Freddie were government-sponsored entities. It meant that they had to be competitive, like a private company, and maintain their stock price. At the same time, the federal government implicitly guaranteed the value of the mortgages they resold on the secondary market. That caused them to hold less capital to support their mortgages in case of loss. As a result, Fannie and Freddie were pressured to take on risk to be profitable. They also knew they wouldn't suffer the consequences if things turned south.

The government set them up this way to allow them to buy qualified mortgages from banks, insure them, and resell them to investors. Banks used the funds to make new mortgages. Throughout the years, Fannie and Freddie supported half of all new mortgages issued each year. By December 2007, when banks began to constrict their lending, they touched 90 percent of all mortgages.

Role During the Housing Crisis

Government regulations prohibited Fannie and Freddie from buying high-risk mortgages. But as the mortgage market changed, so did their business.

Between 2005 and 2007, they acquired few conventional, fixed-interest loans with 20 percent down. They loaded up on subprime, interest-only, or negative amortization mortgages. Those were the types of loans banks and unregulated mortgage brokers issued. 

Fannie and Freddie made things worse by their use of derivatives to hedge the interest-rate risk of their portfolios. But as private sector companies with shareholders to please, they were doing this to remain competitive with other banks. They were all doing the same thing.

Fannie Mae's loan acquisitions were:

  • 62% negative amortization
  • 84% interest only
  • 58% subprime
  • 62% required less than 10% downpayment

Freddie Mac's loans were even more risky, consisting of:

  • 72% negative amortization
  • 97% interest only
  • 67% subprime
  • 68% required less than 10% downpayment

These exotic and subprime mortgages made Fannie and Freddie's loan acquisitions toxic.

Fannie and Freddie Held Fewer Toxic Loans than Most Banks

Regulations made sure Fannie and Freddie took on fewer of these loans than most banks. They acquired more of these loans to maintain market share in a very competitive market. 

In 2005, the Senate sponsored a bill that prohibited them from holding mortgage-backed securities in their portfolio. Congress wanted to reduce the risk to the government. In total, the two GSEs owned or guaranteed $5.5 trillion of the $11.2 trillion mortgage market.

But the Senate bill failed, and Fannie and Freddie increased their holdings of risky loans. They could make more money from the loans' high interest rates than from the fees they got from selling the loans. Again, they were seeking to maintain high stock prices in a very competitive housing market. 

As government-sponsored enterprises, Fannie and Freddie took on more risk than they should have. They didn't protect the taxpayers who ultimately had to absorb their losses. But they didn't cause the housing downturn. They didn't flood the market with exotic loans. Instead, they were a consequence, not a cause, of the mortgage crisis. 

Derivatives Helped Cause Fannie's Downfall

By 2007, only 17 percent of their portfolio was subprime or Alt-A loans. But then housing prices declined, and homeowners began defaulting. As a result, this relatively small percentage of subprime loans contributed 50 percent of the losses.

As GSEs, Fannie and Freddie weren't required to offset the size of their loan portfolio with enough capital from stock sales to cover it. It was a result of both their lobbying efforts and the fact that their loans were insured. Instead, they used derivatives to hedge the interest-rate risk of their portfolios. When the value of the derivatives fell, so did their ability to guarantee loans. 

This exposure to derivatives proved their downfall, as it did for most banks. As housing prices fell, even qualified borrowers ended up owing more than the home was worth. If they needed to sell the house for any reason, there would lose less money by allowing the bank to foreclose. Borrowers in negative amortization and interest-only loans were in even worse shape. 

Eliminating Fannie and Freddie Would Destroy the Housing Market

Some legislators propose eliminating Fannie and Freddie. Others suggest that the United States copy Europe in using covered bonds to finance most home mortgages. With covered bonds, banks retain the credit risk on their home mortgages. They sell bonds backed by those mortgages to outside investors. That allows them to offload interest rate risk.

What would happen if Congress eliminated Fannie and Freddie? It would dramatically reduce the availability of mortgages and increase the cost. Banks hesitate to issue mortgages that aren't guaranteed. Mortgage interest rates could go as high as nine to 10 percent. Mortgages would become rare and expensive. The U.S. housing market would collapse.