Understanding Fannie Mae and Freddie Mac

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Fannie Mae and Freddie Mac are cornerstones of the mortgage market, yet many Americans are unfamiliar with their roles in the mortgage industry. Keep reading to better understand how they work for both US homeowners and the economy.

What Are Fannie Mae and Freddie Mac?

Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) that act as links between banks and lenders, the federal government, and private investors. Their mission is to provide easy access to funds, or “liquidity”, to thousands of banks, savings and loans entities, and other mortgage companies that lend to homebuyers.

Fannie Mae and Freddie Mac do this by purchasing most of the home loans in the United States. They then hold them as their own investments, or package them into mortgage-backed securities that are sold to investors on what is known as the secondary mortgage market. More on that below:

What's the Difference between Fannie Mae and Freddie Mac?

The missions of Fannie Mae and Freddie Mac are similar, but they are separate enterprises that were chartered at different times and for different purposes.

Fannie Mae. The U.S. government created the Federal National Mortgage Association (FNMA), commonly known as Fannie Mae or simply Fannie) in 1938 as part of the New Deal under President Franklin D. Roosevelt. Its original purpose was to buy mortgages from cash-strapped private companies to free up capital that would then encourage lending during the Great Depression. Fannie Mae was later semi-privatized in 1968.

The primary goal of Fannie Mae, in the past and today, is to make more affordable mortgages available to low- and middle-income buyers. Fannie Mae typically buys loans from lenders of all sizes, from large-national banks to small community lenders and credit unions.

Freddie Mac. The federal government later created the Federal Home Loan Mortgage Corporation (FHLMC)—aka Freddie Mac—in 1970 to further increase the availability of mortgages to home buyers. Freddie, also semi-privatized, serves as competition for Fannie Mae, and allows for mortgages to be bundled together and sold as investments on the secondary mortgage market. This bundling and selling allows more people to obtain mortgages because the lenders don't have to hold the loans on their balance sheet, thus freeing up their capital to re-lend and make additional loans.

What Is the Secondary Mortgage Market, and How Does It Work?

Understanding exactly how the secondary mortgage market works can be difficult, particularly because many homebuyers don't know it even exists. Here are the three main steps in the moving a mortgage through the secondary market:

  1. First, a homebuyer finances his/her house through a mortgage lender (such as PennyMac). If the lender is approved to work with Fannie and Freddie, and the lender also verifies that the buyer's loan met their guidelines, then either Fannie Mae or Freddie Mac will purchase that loan after the homebuyer closes.
  2. Fannie or Freddie will either keep the loan, or bundle it with similar loans into a security. Groups of several smaller loans with the same terms (interest rate, length) may be bundled in order to create a single security. This allows Fannie and Freddie to offer investment options of all sizes that are less risky due to the multiple borrowers included in each bundle.
  3. Finally, if the loan is bundled, Fannie and Freddie make a secondary sale by offering this security to investors and providing an insurance policy against losses on loans included in the security.

The result is:

  • Increased market stability, affordability, and liquidity
  • Lenders have less debt owed to them (also known as “on the books” or “on balance-sheet”), resulting in more funds to originate new mortgages
  • Fannie Mae and Freddie Mac have increased capital to buy more loans
  • The investor makes a profit from the interest earned on the borrower's monthly mortgage payments

How Has the Secondary Market Changed Since the 2008 Recession?

The past 20 years have seen drastic changes in the US housing market and this volatility has impacted the secondary mortgage market as well. Home prices in the US housing market reached an all-time high in 2005, just before the recession began, which caused home sales (as well as home values) to begin falling dramatically in 2006.

As a result of these changes, many private equity investment institutions in the U.S. and around the globe became less interested in the secondary mortgage market. Without these investors buying loans, lenders had fewer loans to offer and buyers had fewer options.

In order to bolster the US housing market and the overall economy, Fannie Mae and Freddie Mac became the primary buyers in the secondary market. This kept investors interested, as loans backed by Fannie and Freddie are considered to be safe investments due to their government support. The federal government now invests or insures over 90 percent of mortgages in the US via Fannie Mae, Freddie Mac and Ginnie Mae.

Ginnie Mae: The Lesser-Known Sister of Fannie and Freddie

Another layer of protection for investors is offered in the form of the government agency Ginnie Mae (The Government National Mortgage Association). A part of the Department of Housing and Urban Development, Ginnie Mae guarantees the timely payment of mortgage bonds that include federally insured or guaranteed loans, such as FHA mortgages. Fannie and Freddie guarantee loans to secondary market investors, while Ginnie Mae guarantees mortgage-bond payments.

For example, if a borrower defaults on their mortgage, Fannie and Freddie are responsible for the losses on the loans they guarantee to investors, while Ginnie Mae is financially responsible for the bond payments to the holders of Ginnie Mae securities.

The relationships may seem complicated, but the ultimate goal of each of these three institutions is clear:

  1. To keep rates low and funds available to homebuyers throughout the US
  2. To free up lender capital for further loans
  3. To attract secondary market investors

How Do Homeowners and Potential Buyers Benefit?

While many consumers never come in direct contact with Fannie Mae and Freddie Mac, these two important GSEs do ultimately provide buyers with important benefits through their local banks and other lenders. Some of these benefits include:

  • Secure, lower interest rates and origination fees due to low funding costs
  • Customizable mortgage programs that can help low to moderate income families find more affordable home financing options: Fannie and Freddie are committed to buying a certain amount of these buyer's loans, making it easier for banks to offer them
  • Fannie Mae and Freddie Mac sponsored educational programs that help first-time buyers understand the various loan choices available

Fannie and Freddie: Hidden Help For Homeowners

Fannie Mae and Freddie Mac smooth the path to homeownership in many ways. These quiet mortgage giants help maintain stability, affordability and liquidity of capital for your lenders to use to make high quality home loans. More importantly, these GSEs help homeowners find the right loan for their unique situation by tailoring their program to the needs of a wide range of borrowers.