Congress is talking about replacing Freddie Mac and Fannie Mae, why?

Welcome to the Daily Briefing.

Investors around the world have purchased American mortgages since Congress created the Federal National Mortgage Association in 1938. American mortgages have held the status of the Gold Standard around the world for decades. These investors are important not just from the perspective of buying stock in Freddie Mac and Fannie Mae, but also their faith in the organizations that package these securities. Without this purchasing activity, American real estate, and the related building industry, could suffer drastic contraction.

If we look at the history of efforts to improve the mortgage market the concern over current actions will become apparent from an investment perspective. Starting in 1938, and continuing through 1968, Congress charged the Federal National Mortgage Association (Fannie Mae) with being the sole enterprise responsible for providing liquidity to the mortgage industry by buying mortgages from financial institutions, such as banks and savings and loans. The process was simple, the financial institution would grant a valid, good credit mortgage, and then sell it to Fannie Mae. By doing this, the financial institution was now able to grant another mortgage and on and on. Without Fannie, the financial institution would need to wait until the mortgages they granted earlier were paid off. With Fannie in the picture the financial institution did not need to wait, as they get paid by Fannie up front, and then are able to grant a new loan. This activity is critical to the construction and housing markets in providing liquidity.

Fannie Mae gets the money to buy the original mortgages by packaging the original mortgages into securities, and then selling them to the investment community. The investment community receives an excellent yield on the securities, and Fannie can return to the financial institutions to buy more mortgages. The process provides high quality liquidity to the markets.

The process worked so well that Congress decided to modify the structure and create a new public enterprise specifically for government employees and military personnel. At the same time they privatized Fannie, asking shareholders to become interested in creating shareholder value and becoming owners.  In addition, seeing how Fannie was such a valuable contributor to mortgage liquidity, a second private enterprise was created called the Federal Home Loan Mortgage Corporation known as Freddie Mac.  All three organizations had the same mandate, provide liquidity to the housing market. Mortgage securities were purchased by investors, and shareholder value was created in the private ownership in both enterprises.

Liquidity was excellent, investors were pleased, and the mortgage industry was benefitting. The success was so good that Congress severed the link between the FHLBB with both Freddie and Fannie in 1989. Both organizations were now part of the private market and moving forward. Housing, construction, and the general economy were the beneficiaries.

Congress started encouraging Freddie to increase the granting of sub-prime mortgages. The same mortgages that eventually caused the collapse of the mortgage and housing markets in 2008. The idea was that a certain group of borrowers deserved a second chance and if the sub-prime mortgages were mixed in small quantities, with high quality mortgages, the market would benefit, investors would receive and excellent return, investors value would increase, and the economy would benefit. This worked well; so well that HUD accused Freddie of “not doing enough” to support the sub-prime mortgage segment of the market.  Freddie responded with increased purchases of sub-prime mortgages.

All of this hit a brick wall in 2008 when the real value in mortgage securities came into question, spreading fear throughout the market and quickly killing liquidity. Congress eventually stepped in placing both Freddie and Fannie in conservatorship under the Federal Housing Finance Agency and granted a loan guarantee of $188 billion. The U.S. Treasury purchased $1 billion in preferred stock with a yield of 10%. Shareholder value was wiped out when the enterprises stock was delisted from the exchange.

What occurred was a huge mistake and potentially could have put the globe in financial collapse. The worst case was avoided. Both Freddie and Fannie have returned to profitability and are once again providing valuable liquidity to the markets. Both have helped tremendously in buying mortgages that has correspondingly help put the housing market back in positive territory. Shareholders have also returned to taking ownership in Freddie and Fannie, taking the risk of default on securities, and fortunately coming out the other side successfully. Both organizations are important to the overall market.

With value being recreated, and with two organizations providing valuable liquidity to a struggling market, why is Congress proposing eliminating both organizations, destroying shareholder wealth, and removing liquidity from the housing market? It remains a mystery. But, for whatever reason, it is a concern for investors that might be considering stock ownership in either organization, or considering purchasing any mortgage securities from either organization.

Congress is discussing creating an entirely new organization called the Federal Mortgage Insurance Corporation that will operate in a complex structure of private insurance and public guarantees. This is a major structural change to the housing and construction industry. Investors should be cautious about investments in mortgage securities, housing and construction and especially in direct securities related to either Freddie or Fannie. You may wish to just wait until Congress gets tired of trying to manipulate the housing market.

I hope you have enjoyed this Daily Briefing we will have more tomorrow…

 

Steven A. Albrecht
Chief Executive Officer

Follow me on Twitter @StevenA_USA

www.chartertrust.com • www.moneybasicsradio.com
By | 2014-03-13T09:30:42+00:00 March 13th, 2014|Categories: Money Basics|0 Comments

About the Author:

Steven Albrecht was the President and CEO of Charter Trust Company from 2001-2016

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