Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) — i.e., private companies sponsored by the government — in the U.S. home mortgage industry. Though separate companies that compete with one another, they have the same business model, wherein they buy mortgages on the secondary mortgage market, pool those loans together, and then sell them to investors as mortgage-backed securities in the open market. The main difference between Fannie and Freddie comes down to who they buy mortgages from: Fannie Mae mostly buys mortgage loans from commercial banks, while Freddie Mac mostly buys them from smaller banks that are often called "thrift" banks. The two companies are part of a complex process that keeps money moving through the U.S. housing economy, allowing more people to afford to buy homes than would otherwise be able if Fannie and Freddie did not exist. Since the 2008 financial crisis, when the U.S. government bailed out Fannie and Freddie, the government has had a more direct say in these two businesses.
How Fannie Mae and Freddie Mac Work
Banks lend money to people who want to buy a house. These loans, called mortgages, can be significant, as much as $300,000 or more, and borrowers typically have 15 to 30 years to repay them. With so many people needing mortgages, and with such long periods of time passing before these large debts are repaid, banks could run out of money to loan.
This is where Fannie Mae and Freddie Mac come in. Fannie and Freddie work with lenders, not borrowers. They buy mortgages from banks, which allows the banks to turn a quick profit and gives them the capital necessary to lend again. In general, Fannie buys mortgages from private commercial banks, like Chase and Bank of America, and Freddie buys mortgages from smaller banks, a.k.a., thrifts.
Mortgage debt that Fannie and Freddie buy is then sold to investors as mortgage-backed securities (MBS), often in the form of agency bonds. (Because they are attached to the mortgage market, agency bonds function a little differently from the more common corporate and government bonds, and they often require a minimum investment of $25,000.) Fannie and Freddie guarantee the loans that are bundled into the mortgage-backed securities they sell to investors. In other words, if a borrower defaults on the mortgage, Fannie or Freddie will pay the investor (the ultimate owner of the mortgage debt) instead of the borrower.
Since Fannie Mae and Freddie Mac are government-sponsored agencies, their guarantee is implicitly backed by the full faith and trust of the United States government. In order for Fannie and Freddie to be able to provide such a guarantee, they require originating banks (the banks that originally lend the money directly to the borrower) to make sure they check the creditworthiness of the borrower. Originating banks have to follow certain rules and guidelines (e.g., at least 20% down payment or the requirement to pay mortgage insurance premiums); documented proof of income and ability to repay; documented appraisal of the home by a professional and neutral third party; and so on. These rules and guidelines are meant to reduce the likelihood of a default on the loan.
When all parts of the whole are functioning as they should, more people are able to afford to buy a home, debts are repaid, and investors make money.
Conforming vs. Non-Conforming Loans
Fannie Mae and Freddie Mac directly affect conventional lending for home buying. When dealing with conventional loans, there are two main kinds: conforming and non-conforming. Conforming loans are also sometimes called "qualified mortgages," or QM.
Conforming loans are those which adhere to Fannie and Freddie's guidelines. That is, conforming conventional loans only go to those borrowers who are most likely to pay back their loans — i.e., those who make 20% down payments, have a good credit score, a reliable income, etc. They also do not exceed a certain amount: $417,000, in most cases. A non-conforming loan is a loan that a bank makes that does not adhere to Fannie and Freddie's guidelines. The loan is either made to less creditworthy borrowers or for a larger amount than Fannie and Freddie recommend (see jumbo mortgage). Non-conforming loans are usually higher interest loans to make up for the amount of risk inherently involved in the investment of them; non-conforming loans are common when it comes to buying a condo.
As recently as December 2013, a number of large U.S. banks, including Bank of America, Chase, Citigroup, and Wells Fargo, are issuing non-conforming loans to a small percentage of customers. This is a risky investment for the banks and the investors who buy the mortgage debt, as non-conforming loans are not backed by Fannie and Freddie, making any loan defaults costly for investors and, potentially, for the economy at large.
Fannie Mae and Freddie Mac vs. Ginnie Mae and FHA Loans
Besides Fannie Mae and Freddie Mac, there is Ginnie Mae. Unlike Fannie and Freddie, Ginnie is wholly owned by the U.S. government as a public entity, and all mortgage-backed securities that it sells to investors are explicitly backed by the U.S. government. In contrast, the securities bought from Fannie and Freddie are implicitly — i.e., implied to be — backed. Historically, investing in Ginnie Mae's bonds is safer than investing in those bought from Fannie Mae and Freddie Mac.
Bailout Following the Great Recession
The 2009 stimulus bill "bailed out" Fannie and Freddie. Between the two companies, $187.5 billion was used to keep them afloat. They have since returned this amount and then some — $218.7 billion. This means that bailing out Fannie and Freddie has ultimately become profitable for taxpayers and the U.S. Treasury.
- 1934: Reacting to the Great Depression, the 73rd U.S. Congress passes the National Housing Act of 1934, which creates the Federal Housing Administration. The FHA is tasked with keeping housing market capital flowing so lending and borrowing is more predictable and affordable.
- 1938: The National Housing Act is amended, and Fannie Mae is created as a public entity to further facilitate the flow of capital in the housing market. It is only allowed to buy government-insured mortgages — FHA loans.
- 1954: The Federal National Mortgage Association Charter Act turns Fannie Mae into a "mixed-ownership corporation." The federal government holds Fannie Mae's preferred stock; investors hold the corporation's common stock.
- 1968: Fannie Mae is turned into a private corporation. It is partially split up in the process to create Ginnie Mae, which remains a public operation.
- 1970: The government allows Fannie Mae to begin buying private mortgages that are not insured by the government. Freddie Mac is created to provide further competition in the secondary mortgage market.
- 1992: The Housing and Community Development Act of 1992 requires Fannie Mae and Freddie Mac, as GSEs, to attempt to make housing more affordable. Affordable housing goals are set, with both GSEs required to have at least 30% of their mortgage purchases come from mortgages taken out by low- to moderate-income families and individuals.
- 1999: The New York Times notes that Fannie Mae is taking on much more risk in buying suprime mortgages.
- 2000: Fannie Mae is restricted from buying riskier mortgage loans.
- 2004: Fannie Mae is allowed to buy high-risk mortgages once again.
- 2007: At least 50% of GSEs' mortgage purchases must now come from mortgages taken out by low- to middle-income families and individuals.
- 2008: Due to events related to the subprime mortgage crisis, Fannie Mae and Freddie Mac are placed in a conservatorship of the Federal Housing Finance Agency (FHFA). Fannie and Freddie no longer answer to shareholders, but to the government.
Fannie Mae gets its name from an acronym, FNMA, which stands for Federal National Mortgage Association. Freddie Mac gets its name in the same fashion, though slightly less obviously. It comes from the acronym FHLMC, which is stands for Federal Home Loan Mortgage Corporation. Ginnie Mae's name comes from GNMA, or Government National Mortgage Association.