Did Fannie and Freddie Cause the Mortgage Crisis?

No, They Did Not Cause the Mortgage Crisis. Here's What Did

fannie and freddie
Fannie and Freddie made it possible for many more people to afford their own homes. Photo: Sean Martin/Getty Images

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

Fannie and Freddie were government-sponsored entities (GSEs).

It meant that they had to be competitive, like a private company, and maintain their stock price. On the other hand, the value of the mortgages they re-sold on the secondary market was implicitly guaranteed by the government. 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 but 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, insure them and resell them to investors, thus freeing up funds for banks to make new mortgages. In this way, they were traditionally involved in at least half of all new mortgages made each year. By December 2007, when banks began to constrict their lending, Fannie and Freddie were the only lenders still operating, responsible for 90% of all mortgages.

Government regulations precluded Fannie and Freddie from buying mortgages that didn't meet down payment and credit requirements.

But as the mortgage market changed, so did their business.

Between 2005-2007, few of the mortgages they acquired were conventional, fixed-interest loans with 20% down. In fact, most of the mortgages they bought or guaranteed were either subprime, interest-only or negative amortization. That's because those were the types of loans being made by banks and unregulated mortgage brokers.

 ItT was made 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.

Government regulations precluded Fannie and Freddie from buying mortgages that didn't meet down payment and credit requirements. That meant they bought, resold or guaranteed 50% of the mortgages made, but it was the most credible half. By 2007, only 17% of their portfolio was subprime or Alt-A loans. But when housing prices declined, and homeowners began defaulting, this relatively small percentage of subprime loans contributed 50% of the losses.

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.

It was the preponderance of exotic loans in addition to subprime borrowers that made Fannie and Freddie's loan acquisitions so toxic.

Fannie and Freddie Held Fewer Toxic Loans than Most Banks

It is critical to understand, however, that because of regulations, they took on less of these loans than most banks.

According to several analysts, they increased their acquisition of these loans to maintain market share in what had become a very competitive market. (Source: (Source: SeekingAlpha, How Much Are Fannie and Freddie to Blame?, October 2, 2008; Washington Post Fannie and Freddie Become Hot Topic, October 10, 2008)

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

After the Senate bill failed, Fannie and Freddie increased their holdings of risky loans. That's because 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 during a very competitive housing market. (Source: Barron's, Is Fannie Mae the Next Government Bailout?, March 10, 2008; IHT, Fannie and Freddie's blame game, August 24, 2008)

As government-sponsored enterprises, Fannie and Freddie took on more risk than they should have, since taxpayers 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 an example, not a cause, of the mortgage crisis. 

Derivatives Helped Cause Fannie's Downfall

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, so they felt they didn't need to. 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 insure loans. (Source: NYT, Fannie, Freddie and You, July 14, 2008)

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. 

Elimination of Fannie and Freddie Could Destroy Any Housing Recovery

Some legislators propose eliminating Fannie and Freddie. Others suggest that the U.S. copy Europe in using covered bonds to finance most home mortgages. With covered bonds, banks retain the credit risk on their home mortgages, but sell bonds backed by those mortgages to outside investors, thus off-loading interest-rate risk.

Elimination of Fannie and Freddie would dramatically reduce the availability of mortgages and increase the cost. Banks have not, and would not, step in to guarantee mortgages. Studies have shown that, without Fannie and Freddie, mortgage interest rates could go as high as 9-10%. That would damage the housing market before it had any chance to recover. (Source: Barron's, Life After the Old Fannie and Freddie, September 15, 2008)