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Why did Freddie Mac and Fannie Mae Go Under?

Published by Lawrence Roberts | December 26th 2008 | Views:

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The Federal Home Loan Mortgage Corporation, also known as Freddie Mac, was created by Congress in 1970 to make possible a secondary mortgage market to provide greater liquidity to banks and other lending institutions to facilitate home mortgage lending. The Federal National Mortgage Corporation, also known as Fannie Mae, was originally created by the Federal Housing Authority (FHA) in 1938. In the beginning, Fannie Mae would securitize FHA loans, and it was the first to create a secondary mortgage market.

In 1968, the company was privatized to remove its debt from the balance sheet of the Federal Government. Fannie Mae's role in purchasing FHA loans was replaced by the Government National Mortgage Association, also known as Ginnie Mae. Both Freddie Mac and Fannie Mae are private corporations that have the implied backing of the Federal Government even though their activities are explicitly not guaranteed (until they were taken into conservatorship in September 2008). Collectively Freddie Mac, Fannie Mae and Ginnie Mae are known as Government Sponsored Entities or GSEs, and they are responsible for maintaining a secondary market for mortgage backed securities.

Fannie Mae and Freddie Mac buy and sell mortgage loans to create a secondary market. Mortgage originators bring groups of loans to the two companies which will either buy the loans to hold in their own portfolios, or they will bundle these loans together into securities in ahe guarantee amount).

Fannie Mae and Freddie Mac have strict loan origination guidelines because of the insurance they are providing. In the terms of the mortgage industry, "conforming" loans are those loans that meet the underwriting standards of Fannie Mae and Freddie Mac. In the later stages of the rally in the Great Housing Bubble, more and more mortgage loans were being originated that did not conform to Fannie Mae's and Freddie Mac's standards. The asset-backed securities (ABS) market packages these non-conforming loans into collateralized debt obligations and garnered significant market share.

Despite their more conservative lending standards, Fannie Mae and Freddie Mac guaranteed many loans that performed poorly in the fallout of the Great Housing Bubble. They guaranteed many exotic loan types with inflated appraisals and committed many of the same errors as asset-backed securities (ABS) issuers during the bubble. When these loans started to go bad, Fannie Mae and Freddie Mac faced enormous losses, so the government had to assume conservatorship in 2008.
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