Government Sponsored Enterprises

The Government Sponsored Enterprises (GSE) play an important role in the mortgage market. Fannie Mae and Freddie Mac contribute to the increase of homeowners in the country through the symbiotic relationship they have with government.

The GSEs develop programs specifically targeted to first-time homebuyers and operate under the supervision of the Office of Federal Housing Enterprise Oversight (OFHEO). The government’s contribution is granting them access to a credit line from the US Treasury and allowing them to operate with lower cash reserves than the private industry is required to have. This lower cost of operation is then passed onto the marketplace. That’s why mortgages that are underwritten to conform to Fannie or Freddie standards carry a lower interest rate.

Before we see how the GSEs impact today’s mortgage market we need to take a look at how they evolved. Fannie Mae website will supply you with a more detailed history but this brief summary will give us all we need right now.

The FHA Administrator chartered Fannie Mae on February 10, 1938. The impetus for creation of Fannie Mae was twofold: the national commitment to housing and the inability or unwillingness of private lenders to ensure a reliable supply of mortgage credit throughout the country. The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans that had been originated by private lenders. After World War II, Fannie Mae's authority was expanded to include VA-guaranteed home mortgages.

The 1968 Charter Act split Fannie Mae into two parts: Ginnie Mae and a reconstituted Fannie Mae. Ginnie Mae would continue as a federal agency and be responsible for the then-existing special assistance programs, and Fannie Mae would be transformed into a "government-sponsored private corporation" responsible for the self-supporting secondary market operations. The reconstituted Fannie Mae was to be stockholder-owned and managed. Fannie Mae retired the last of its government stock on September 30, 1968, and transformation to a government-sponsored private corporation was completed in 1970. The 1968 Act provided the authority to issue Mortgage-Backed Securities (MBS).The Act also established a regulatory structure to ensure Fannie Mae's adherence to its public purpose. It provided for continuing HUD oversight of Fannie Mae, granting "general regulatory power ... to insure that the purposes of this Title are accomplished."

The Emergency Home Finance Act of 1970 created Freddie Mac and authorized it to create a secondary market for conventional mortgages. Parallel authority and limitations to deal in conventional mortgages were given to Fannie Mae.The Federal Housing Enterprises Financial Safety and Soundness Act ("FHEFSSA") of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. It created the Office of Federal Housing Enterprise Oversight ("OFHEO") as a new regulatory office within HUD with the responsibility to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely."

OFHEO is funded by assessments on Fannie Mae and Freddie Mac and is authorized to act without HUD oversight on a range of regulatory issues enumerated in the statute. FHEFSSA established risk-based and minimum capital standards for Fannie Mae and Freddie Mac. And, it established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.

Fannie Mae and Freddie Mac purchase over 50% of the mortgages originated in the country. Because of their market share they essentially wrote the underwriting standards for the industry as well as developed nearly all of the standard documents that the industry uses. The public purpose component of their mission is to maintain an orderly mortgage market, encourage homeownership to as many consumers as possible and to keep the cost of mortgage financing as low as possible.

Roughly 2 years ago both agencies were involved in accounting scandals. There were several companies involved in accounting scandals at the time but the GSEs issues were different. Companies typically try to make their financial statements look as profitable as possible. A more profitable company yields higher stock prices and that makes shareholders happy. When accountants get too creative in their jobs they find themselves crossing the line and break the law, this creates the scandal.

The GSEs were caught declaring less income than they actually made that year. Their reason was they were smoothing out their income over the years. They felt that consistency in year-to-year profits made for a better public image. It doesn’t matter if their intentions were good or bad. It was not an accepted practice, it was unlawful and they were forced to reissue their financial statements for several years. Coming off the boom years their profits, as you would have expected, were extremely high.

Combine record high profits with their government mandates and you have the foundation for a problem. The government, seeing the record profits, pushed the GSE’s to purchase mortgages with a lower credit grade than they historically did. The feeling was that the profits weren’t due to an overactive housing market but due to underwriting standards that were too conservative.

Not all mortgages perform perfectly. They is always a percentage of borrowers that don’t live up to their contractual obligations with their lenders. The reasons that borrowers can’t keep their mortgages current are numerous. There could be a job loss, a medical emergency, a natural disaster, a divorce, etc. Things happen in lifenand they aren’t always good things.

A lender, or an investor in mortgages, tries to predict the percentage of mortgages that are not going to perform before pricing the mortgage or pools of mortgages. This is a very important piece of information because that is the largest factor in the profitability of the final decision. If the prediction is more than the actual number of defaults, the investor finds himself making more money that he expected. If the prediction is too low, meaning that more mortgages go into default than planned, the profit seen by the investor is less than expected or could even become a loss.

In an attempt to maintain the growing percentage of people becoming homeowners in the country and to offer lower cost financing to more people, the government made the GSEs revise their lending standards. Their profits were high because the rate of defaults were lower than anticipated. This was viewed as justification in requiring the underwriting standards to be lowered. The GSEs were now purchasing mortgages that were considered Alt-A or Subprime previously.

What’s been happening over the last 6 months is that the portfolio of mortgages held by the GSEs were no longer performing as well as they had been. Not only were the newer mortgages not performing as well as they were expected to but the default rate of the entire portfolio was increasing. The net result is that both agencies are no longer in a strong financial position. Their stock prices have suffered and they are raising their cash reserves to handle the higher level of defaults. This will prove to be a manageable problem for the GSEs. They are large enough and financially strong enough to weather this.

The biggest problem is that the public is losing confidence in the GSEs and this is fueling their negative attitude to the housing market. The average person is seeing the large drop in profitability from last year to this year but they are not taking into account that last year was a record year. Once the financials of Fannie and Freddie are looked at over a several year period, a different conclusion becomes evident. Yes, this is a bad year for both GSEs, there is no argument there. A longer historical prospective will yield a more accurate evaluation of the magnitude of the situation.

The facts are that the more liberal underwriting standards that the GSEs used, made a substantial contribution to the problems in the housing market today. Both the GSEs and the government had the best of intentions; more people becoming homeowners and at a lower cost. Unfortunately, it encouraged some people to take on more debt than they were financially ready for resulting in a mortgage default that could quickly become a foreclosure statistic.

We shouldn’t condemn the GSEs for lowering their standards. Not every mortgage closed under these standards went into default. We need to encourage Fannie and Freddie to review their standards and make revisions as needed, that will allow them to continue to fulfill their government mandates and at the same time maintain adequate profits.

The GSEs share responsibility for the mortgage crisis in yet another way. We’ve just shown that one of the consequences of lowering their underwriting standards was an increase in their default rate. An increase that was larger than they anticipated. In lowering their standards, they began funding the better-qualified Alt-A and Subprime borrowers. The lenders who specialized in Alt-A and Subprime were now loosing their better borrowers. This meant that these lenders would now be exposed to a higher rate of default because the better quality mortgages that were adding stability to their portfolio were now elsewhere.

The problems in the mortgage market caused by the aggressive lending policies of the Subprime lenders were now being magnified. Less qualified borrowers were being given mortgages which resulted in higher defaults and at the same time, their better-qualified borrowers were leaving the Subpirme marketplace. The default rate was now being pushed up from both sides.

The GSEs need to avoid fast changes in their underwriting standards no matter how much they are pushed by the government. Revisions need to be done slowly so as not to shock the marketplace. They need to be careful now and not tighten their standards too much, too quickly, in response to the current market. An overreaction now will cause serious damage and only make matter worse.