Artful Dodger: Close enough (for government work)

http://www.investopedia.com/articles/economics/08/fannie-mae-freddie-mac-credit-crisis.asp

When the housing bubble of 2001-2007 burst, it caused a mortgage security meltdown. This contributed to a general credit crisis, which evolved into a worldwide financial crisis. Many critics have held the United States Congress - and its unwillingness to rein in Fannie Mae and Freddie Mac - responsible for the credit crisis. In this article, we'll examine the extent to which Fannie Mae, Freddie Mac and their allies in Congress contributed to the largest financial and economic crisis since the Great Depression.


A Brief History of Mortgage Markets

For most of the twentieth century, mortgage lending took place mostly at banks, thrifts, credit unions, and savings and loans. The most common type of mortgage was a fixed-rate mortgage and most of the financial institutions originating mortgages held the mortgages that they originated on their books. Starting in 1968, when Fannie Mae was chartered by the U.S. Congress as a government-sponsored enterprise (GSE), and two years later when Freddie Mac was chartered as the same, things began to change quickly. (Fannie Mae was originally created in 1938, but until its privatization in 1968 it was a part of the U.S. government). Fannie Mae and Freddie Mac created a liquid secondary market for mortgages. This meant that financial institutions no longer had to hold onto the mortgages they originated, but could sell them into the secondary market shortly after origination. This in turn freed up their funds such that they could then make additional mortgages.

Fannie Mae and Freddie Mac had a positive influence on the mortgage market by increasing home ownership rates in the United States; however, as history has proved, allowing Fannie Mae and Freddie Mac to function as implied government-backed monopolies had major repercussions that far outweighed the benefits these organizations provided.

The Privileges of GSE Status

According to Fannie Mae and Freddie Mac's congressional charters, which gave them GSE status, they operated with certain ties to the United States federal government and, as of September 6, 2008, were placed under the direct supervision of the federal government. According to their congressional charters:

•The president of the United States appoints five of the 18 members of the organizations' boards of directors.

•To support their liquidity, the secretary of the Treasury is authorized, but not required, to purchase up to $2.25 billion of securities from each company.

•Both companies are exempt from state and local taxes.

•Both companies are regulated by the Department of Housing and Urban Development (HUD) and the Federal Housing Finance Agency (FHFA). The FHFA regulates the financial safety and soundness of Fannie Mae and Freddie Mac, including implementing, enforcing and monitoring their capital standards, and limiting the size of their mortgage investment portfolios; HUD is responsible for Fannie and Freddie's general housing missions.

Fannie and Freddie's GSE status created certain perceptions in the marketplace, the first of which was that the federal government would step in and bail these organizations out if either firm ever ran into financial trouble. This was known as an "implicit guarantee".

The fact that the market believed in this implicit guarantee allowed Fannie Mae and Freddie Mac to borrow money in the bond market at lower rates (yields) than other financial institutions. The yields on Fannie Mae and Freddie Mac's corporate debt, known as agency debt, was historically about 35 basis points (.35%) higher than U.S. Treasury bonds, while 'AAA-rated' financial firms' debt was historically about 70 basis points (.7%) higher than U.S. Treasury bonds. A 35-basis-point difference might not seem like a lot, but on borrowings measured in trillions of dollars, it adds up to huge sums of money.

With a funding advantage over their Wall Street rivals, Fannie Mae and Freddie Mac made large profits for more than two decades. Over this time period, there was frequent debate and analysis among financial and housing market professionals, government officials, members of Congress and the executive branch about whether Fannie and Freddie's implied government backing was working mostly to benefit the companies, their management and their investors, or U.S. homeowners (particularly low-income homeowners) as was part of these firms' HUD-administered housing mission.

One thing was clear: Fannie Mae and Freddie Mac were given a government-sponsored monopoly on a large part of the U.S. secondary mortgage market. It is this monopoly, combined with the government's implicit guarantee to keep these firms afloat, that would later contribute to the mortgage market's collapse.