Fannie Mae and Freddie Mac 101: How much will we miss them?

Since the financial crisis began, Fannie Mae and Freddie Mac, which buy and insure mortgages, have needed $150 billion in support from Uncle Sam. Now, the US Treasury is exploring ways to wind down its involvement with the mortgage giants.

On Friday, Treasury Secretary Tim Geithner issued a white paper discussing the government’s options and the Obama administration’s plan, which he says “dramatically transforms the role of government in the housing market.”

Mr. Geithner’s aim, according to the white paper, is for the government’s main role to be “limited to robust oversight and consumer protection, targeted assistance for low-and-moderate income homeowners and renters, and carefully designed support for market stability and crisis response.”

Here is some background on the housing giants and the Obama administration’s plan:

Who are Fannie and Freddie?

In 1938, as part of the New Deal, President Franklin Roosevelt created the Federal National Mortgage Association, now known as Fannie Mae, whose mission was to provide local lenders with federal money to finance home mortgages.

During the Vietnam war, in 1968, President Lyndon Johnson privatized Fannie Mae to remove it from the federal government’s balance sheet and created another quasi-private company, the Federal Home Mortgage Corporation, known as Freddie Mac, which would deal with the savings banks. By 1980, they were encouraged to compete against each other.

Both Fannie Mae and Freddie Mac had unusual structures: they were private companies with private shareholders but were protected financially by the US government. As such, they became known as Government Sponsored Enterprises (GSEs) and were exempt from US Securities and Exchange Cmmission regulation, exempt from state and local taxes, and had a line of credit from the US Treasury.

Initially, their role was to establish benchmarks for loans, and through transparency help reduce interest rates for borrowers by bringing standardization to the industry. Later, they began buying home loans made by banks, in order to free up banks to make more loans. In turn, Fannie and Freddie, like private lenders, packaged those mortgages together and sold them to investors all over the world who were enticed by the implicit government guarantee.

What is the status of the two organizations?

In 2008, after the credit markets froze and the housing market collapsed, both companies experienced enormous losses to the value of their portfolios, which had also become increasingly filled with risky mortgages. The Bush administration was forced to place them into a conservatorship, where they remain today.

In order to prop up both organizations and the mortgage market, the US Treasury has added $150 billion total to the lenders’ balance sheets.

Since the government takeover, Fannie and Freddie have tightened their lending standards in terms of requiring higher FICO scores, raising their fees, and requiring a larger downpayment.

“These changes are falling disproportionately on the underserved and working class who do not have the downpayment, or value in their house, or higher FICO scores,” says John Taylor, CEO of the National Community Reinvestment Coalition, a Washington-based organization that lobbies for working-class families.

How important are the companies to the mortgage market?

The two companies represent 50 percent of all US first mortgages issued in recent decades. But on an ongoing basis, they are even more important since the private mortgage market has shrunk considerably.

Fannie and Freddie represent about 70 percent of all new mortgages, while the Federal Housing Administration (FHA) is another 20 percent, estimates Alex Pollock, a housing expert at the American Enterprise Institute.

If the GSEs were not making the loans, “the immediate crisis would have been worse,” says Mr. Pollock. “When you have a crisis you universally have government interventions to get you through the crisis.”

How much debt do the companies have, and who owns it?

Both Fannie and Freddie have a combined debt of $5 trillion, most of it secured by actual mortgages. Some $1.5 trillion is not secured but considered to be guaranteed by the US government.

Pollock says a significant amount of the debt is held by foreign investors. “Bonds were sold all over the world and the investors were told it was the same as buying a US Treasury bill but you get a higher yield,” says Pollock.

Although the shareholders of Fannie and Freddie lost their entire investments after the government took them over, the bond holders have had no losses.

Are the taxpayers liable for repaying this debt?

Although there might be legal questions about this, Pollock says the government is effectively responsible. Some people call this an “implicit” guarantee.

“If the government guarantee did not exist, they would be unable to borrow money because they have no reserves at the moment,” says Pollock. “They are effectively insolvent.”

How does the Obama administration propose to change the situation?

It wants to “wind down” both Fannie and Freddie. To do this, it proposes efforts such as requiring the GSEs to raise their guarantee fees to the same level as private banks or financial institutions, reduce the amount of money they will loan for a mortgage, and reduce the size of their investment portfolios. The goal, according to the white paper, is to give private capital the “predominant role” in housing finance.

What are the options outlined by the US Treasury?

The first option is to privatize housing finance with the government’s role limited to FHA, US Department of Agriculture, and Veterans’ Affairs assistance for narrowly targeted groups of borrowers.

The second option is the same as the first, but government assistance would be scaled up during a time of crisis.

The third option is for private housing finance with assistance from FHA, USDA, and Veterans’ Affairs for low-and-middle income borrowers.

“The first two options are variants of the same thing,” says Sarah Rosen Wartell, executive vice president at the Center for American Progress, a progressive think tank. “From my perspective, the third option is a way to accomplish the goals of the old system but not eliminating some of the risks."

How long will the process take?

The Treasury envisions reform legislation could take several years before it is finally signed by the president. The actual implementation would take several more years.

“Reform will not come overnight,” says the Treasury. “Some reform can take place immediately, like improvements to consumer protection and government oversight, while others will be implemented more gradually as the housing market heals.”