The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. It is a government-sponsored enterprise (GSE) and has been a publicly traded company since 1968. The corporation’s purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS), allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market by reducing the reliance on locally-based savings and loan associations (aka “thrifts”).
In 1970, the federal government authorized Fannie Mae to purchase conventional mortgages.
In 1981, Fannie Mae issued its first mortgage pass through and called it a mortgage-backed security. The Fannie Mae laws did not require the Banks to hand out subprime loans in any way.
In 1992, President George H.W. Bush signed the Housing and Community Development Act of 1992. The Act amended the charter of Fannie Mae and Freddie Mac to reflect the Democratic Congress’ view that the GSEs “… have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return;” For the first time, the GSEs were required to meet “affordable housing goals” set annually by the Department of Housing and Urban Development (HUD) and approved by Congress. The initial annual goal for low-income and moderate-income mortgage purchases for each GSE was 30% of the total number of dwelling units financed by mortgage purchases and increased to 55% by 2007.
In 1999, Fannie Mae came under pressure from the Clinton administration to expand mortgage loans to low and moderate income borrowers by increasing the ratios of their loan portfolios in distressed inner city areas designated in the Community Reinvestment Act (CRA) of 1977. Additionally, institutions in the primary mortgage market pressed Fannie Mae to ease credit requirements on the mortgages it was willing to purchase, enabling them to make loans to subprime borrowers at interest rates higher than conventional loans.
In 1999, The New York Times reported that with the corporation’s move towards the subprime market “Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”
In 2000, because of a re-assessment of the housing market by HUD, anti-predatory lending rules were put into place that disallowed risky, high-cost loans from being credited toward affordable housing goals.
In 2004, these rules were dropped and high-risk loans were again counted toward affordable housing goals. The intent was that Fannie Mae’s enforcement of the underwriting standards they maintained for standard conforming mortgages would also provide safe and stable means of lending to buyers who did not have prime credit. Instead Fannie Mae’s underwriting requirements drove business into the arms of the private mortgage industry who marketed aggressive products without regard to future consequences. Private mortgage lenders were offering a range of loans that layered teaser rates, interest-only, negative amortization and payment options and low-documentation requirements on top of floating-rate loans.
In early 2005, Fannie Mae began sounding their concerns about this “layered-risk” lending. Tom Lund, the head of our single-family mortgage business, publicly stated, “One of the things we don’t feel good about right now as we look into this marketplace is more homebuyers being put into programs that have more risk. Those products are for more sophisticated buyers. Does it make sense for borrowers to take on risk they may not be aware of? Are we setting them up for failure? As a result, we gave up significant market share to our competitors.”
Following their mission to meet federal Housing and Urban Development (HUD) housing goals, GSEs such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBanks) had striven to improve home ownership of low and middle income families, underserved areas, and generally through special affordable methods such as “the ability to obtain a 30-year fixed-rate mortgage with a low down payment… and the continuous availability of mortgage credit under a wide range of economic conditions.” Then in 2003–2004, the subprime mortgage crisis began. The market shifted away from regulated GSE’s and radically toward Mortgage Backed Securities (MBS) issued by unregulated private-label securitization conduits, typically operated by investment banks.
As mortgage originators began to distribute more and more of their loans through private label MBS’s, GSE’s lost the ability to monitor and control mortgage originators. Competition between the GSEs and private securitizers for loans further undermined GSEs power and strengthened mortgage originators. This contributed to a decline in underwriting standards and was a major cause of the financial crisis.
Investment bank securitizers were more willing to securitize risky loans because they generally retained minimal risk. Whereas the GSE’s guaranteed the performance of their MBS’s, private securitizers generally did not, and might only retain a thin slice of risk. Often, banks would offload this risk to insurance companies or other counterparties through credit default swaps, making their actual risk exposures extremely difficult for investors and creditors to discern.
The shift toward riskier mortgages and private label MBS distribution occurred as financial institutions sought to maintain earnings levels that had been elevated during 2001–2003 by an unprecedented refinancing boom due to historically low interest rates. Earnings depended on volume, so maintaining elevated earnings levels necessitated expanding the borrower pool using lower underwriting standards and new products that the GSE’s would not (initially) securitize. Thus, the shift away from GSE securitization to private-label securitization (PLS) also corresponded with a shift in mortgage product type, from traditional, amortizing, fixed-rate mortgages (FRM’s) to nontraditional, structurally riskier, nonamortizing, adjustable-rate mortgages (ARM’s), and in the start of a sharp deterioration in mortgage underwriting standards. The growth of PLS, however, forced the GSEs to lower their underwriting standards in an attempt to reclaim lost market share to please their private shareholders. Shareholder pressure pushed the GSEs into competition with PLS for market share, and the GSEs loosened their guarantee business underwriting standards in order to compete.
The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing finance that led, in 2006, to an increasing number of borrowers, often with poor credit, who were unable to pay their mortgages – particularly with adjustable rate mortgages (ARM), caused a precipitous increase in home foreclosures. As a result, home prices declined as increasing foreclosures added to the already large inventory of homes and stricter lending standards made it more and more difficult for borrowers to get mortgages. This depreciation in home prices led to growing losses for the GSEs, which back the majority of US mortgages.
In July 2008, the government attempted to ease market fears by reiterating their view that “Fannie Mae and Freddie Mac play a central role in the US housing finance system”.
In the meantime, Paulson said, “Mr. President, we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
Subsequently, Paulson said to the CEOs of the GSEs, “Here’s our idea for how to save you. Why don’t we just take you over and throw you out of your jobs, and do it in a way that protects the taxpayer to the disadvantage of your shareholders?”
Reference: Wikipedia and “On the Brink” written by Henry Paulson.