11 Aug

So What’s Up with Fannie Mae and Freddie Mac and Why is it Important to Me?

August 11, 2008

As you might have noticed in the news recently, there is a proliferation of discussion pertaining to Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac were both set up by the Federal Government – Fannie in 1938 and Freddie in 1970. Neither deals directly with homeowners. Just to give you a little history on how these two entities fit into the big picture, the following is a brief description of the Subprime debacle.

  • Lenders and banks drastically relaxed their underwriting standards in response to the euphoria associated with rapidly rising home prices during 2000-2006. They approved loans that could not possibly be repaid without continually rising home prices.
  • Bank regulators ignored the weak underwriting practices until it was too late to take action.
  • In the meantime, mortgage brokers and loan officers encouraged borrowers to buy more house than they could afford using devices like interest-only mortgages that the borrowers probably did not truly understand.
  • Of course, the borrowers allowed themselves to be seduced into buying houses they couldn’t afford. There was also buying of second or third homes and, last but not least, taking equity out of the properties to up the all-important lifestyle.
  • As the housing market slowed and home prices dropped, this house of cards also fell, and a wave of foreclosures began.

Fannie Mae and Freddie Mac fit into this picture because they buy mortgages away from the banks or lending companies that already hold them. They then bundle these loans together and sell them as mortgage-backed securities that pay a guaranteed rate of return. They also buy and hold these bundles for their own portfolio. Fannie Mae and Freddie Mac have both made very sound investments in the bundled loans they have bought – the only subprime loans they have are the very top tier. The problem that is being created with Fannie and Freddie is that the investing public is running scared – subprime and the public and the bond market is selling instead of buying these mortgage-backed securities – this creates a cash flow problem for Fannie and Freddie as the perception is that all mortgage-backed securities are to be avoided.

The thing is, most of the bundled mortgages that Fannie and Freddie hold are “good” mortgages – I personally have a 15 year fixed mortgage with only 1/3 of the value of my home left to be paid off. There are a lot of people like myself that actually have cash invested in their home. People with subprime mortgages don’t have money in their homes and they have walked away when they’ve gotten “under water”.

This is the reason it is critical to the US economy that the government supports Fannie and Freddie – all those “good” loans have got to be financed to keep the economy robust. What if you had great credit, weren’t overbuying on a house, and you still couldn’t get a mortgage? It is imperative that even if Fannie and Freddie are in a cash flow crunch caused by people wanting to avoid all mortgage-backed issues, we’ve got to give them cash until the stress settles and they’re cash flowing on their own again. Anything else would have hugely negative consequences on the entire financial system.

By the way, the next question you have to ask:  Is this a buying opportunity in the mortgage-backed market? There is more than a 2% spread (yield) over like treasuries.

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