Two of the biggest players in the recent economic and financial debacle were the government sponsored enterprises known colloquially as Fannie Mae and Freddie Mac. But what exactly are they? What did they do to earn such infamy? Here are the answers.
Fannie Mae, the Federal National Mortgage Association, was established by the Roosevelt Administration in 1938. Its purpose was to guarantee home loans made by banks, and to repackage these as securities and sell them on the open market. In effect, it was intended both to insure banks against a widespread default by mortgage holders, and against a withdrawal of capital by depositors.
Freddie Mac, the Federal Home Loan Corporation, was established in the 1970s to expand the secondary market for home loans in the United States, and to compete with Fannie Mae. Its job was largely identical to that of Fannie Mae: guarantee home loans, and then repackage them.
A little bit more detail on how these two companies function is probably useful. The process by which a home loan is repackaged and “securitized” is somewhat complicated. The way it starts is like this: A man takes out a loan on his home for $10,000. The bank that makes the loan then sells the mortgage to another, much bigger bank. In essence, this means that the big bank gives the little bank cash, and the little bank turns over the right to collect on the mortgage to the big bank. The big bank, in turn, wants to resell the mortgage. Once it has bought up a few million, it creates a mortgage-backed security (in effect, a contract that says that the purchaser or the mortgage-backed security will give the bank cash, and in exchange receive the right to collect on the home loan). It then chops the mortgage-backed security up into lots of smaller pieces called “tranches” – so any investor can buy the financial equivalent of a time-share in a mortgage-backed security.
Where do Freddie Mac and Fannie Mae come in? Well, right off the bat, when the loan was first made, they provided “insurance” for the loan. They made what amounts to a bet that said this: We (Freddie and Fannie) bet that 1 in every 100 mortgages will be defaulted on. So, if you pay us the value of 1.1 mortgages, we promise to cover the cost of all defaults on your first 100 mortgages.
The bet only works if Freddie and Fannie have the odds right – and, it turns out, they didn’t, and they wound up on the hook for 1.5 trillion dollars, which the government had to provide them with to keep them solvent. So, the difference between Freddie and Fannie is really just the name. They’re both just broke government-sponsored enterprises that failed in the same market, using the same tactics.