Fannie mae and freddie mac securities

What Are Fannie Mae and Freddie Mac Securities?

Fannie Mae and Freddie Mac securities are a type of mortgage-backed security (MBS) issued by two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These securities represent an ownership interest in pools of residential mortgage loans. As key players in the secondary mortgage market, Fannie Mae and Freddie Mac purchase mortgages from lenders, package them into these securities, and then sell them to investors, providing crucial liquidity to the housing finance system. This process allows lenders to replenish their funds and originate new mortgages, ensuring a continuous flow of housing finance. These securities fall under the broader category of fixed-income investments.

History and Origin

The origins of Fannie Mae and Freddie Mac securities are rooted in the Great Depression and the need to stabilize the U.S. housing market. Fannie Mae, originally known as the Federal National Mortgage Association, was established by Congress in 1938 as part of President Franklin D. Roosevelt's New Deal initiatives. Its initial purpose was to create a secondary market for mortgages insured by the Federal Housing Administration (FHA), thereby providing liquidity to lenders and making homeownership more accessible.²⁸, ²⁹

In 1968, Fannie Mae was reorganized into a privately held, shareholder-owned company, removing its activities and debt from the federal budget. To introduce competition and further expand the secondary mortgage market, Congress passed the Emergency Home Finance Act of 1970, which established the Federal Home Loan Mortgage Corporation, or Freddie Mac.²⁶, ²⁷ Freddie Mac's creation aimed to serve smaller savings and loan associations. In 1971, Freddie Mac issued the first conventional loan MBS.²⁵

Both Fannie Mae and Freddie Mac became pivotal in the housing market, purchasing and securitizing a significant portion of residential mortgages. However, their implicit government backing led to concerns about systemic risk, which came to a head during the 2008 financial crisis.²⁴ Due to substantial losses and market concerns, the Federal Housing Finance Agency (FHFA) placed both Fannie Mae and Freddie Mac into conservatorship on September 6, 2008.²¹, ²², ²³ This action, described as one of the most sweeping government interventions in private financial markets in decades, aimed to stabilize the GSEs and the broader mortgage market.²⁰ As of 2024, Fannie Mae and Freddie Mac remain under conservatorship.

Key Takeaways

• Fannie Mae and Freddie Mac securities are mortgage-backed securities (MBS) issued by two government-sponsored enterprises (GSEs).
• They play a crucial role in the secondary mortgage market by providing liquidity to lenders.
• These securities enable a continuous flow of funds for new mortgage originations, supporting homeownership.
• Fannie Mae was established in 1938, and Freddie Mac was established in 1970, both to stabilize and expand the mortgage market.
• Both entities were placed into government conservatorship in 2008 following the financial crisis and remain so today.

Formula and Calculation

Fannie Mae and Freddie Mac securities represent an interest in a pool of mortgages, so their value is derived from the underlying mortgage loans. While there isn't a single formula to "calculate" Fannie Mae and Freddie Mac securities themselves, their pricing and performance are influenced by several factors inherent in the underlying mortgages. Key components include:

• Principal Balance: The outstanding amount of the loans in the pool.
• Interest Rate: The weighted average interest rate of the mortgages within the pool. interest rate
• Weighted Average Maturity (WAM): The average number of months remaining until the mortgages in the pool are fully repaid.
• Weighted Average Life (WAL): The estimated average time until each dollar of principal is repaid, considering prepayments.
• Prepayment Speed: The rate at which borrowers repay their mortgages earlier than scheduled, often measured by the Conditional Prepayment Rate (CPR) or Public Securities Association (PSA) model. Prepayments can significantly impact the cash flow of MBS. cash flow

Investors analyze these factors to project the future cash flows from the securities and determine their present value.

Interpreting Fannie Mae and Freddie Mac Securities

Interpreting Fannie Mae and Freddie Mac securities involves understanding their characteristics as fixed-income instruments and the unique risks associated with mortgage-backed securities. These securities are generally considered to have relatively low credit risk because Fannie Mae and Freddie Mac guarantee the timely payment of principal and interest to investors, even if the underlying borrowers default.¹⁸, ¹⁹

However, investors must consider prepayment risk. When interest rates fall, homeowners are more likely to refinance their mortgages, leading to faster prepayments of the principal in the MBS. This means investors receive their principal back sooner than expected, which they then have to reinvest at lower prevailing interest rates, potentially reducing their overall returns. Conversely, when interest rates rise, prepayments slow down, extending the average life of the securities and exposing investors to a longer period of lower-yielding assets, a concept known as extension risk. Investors evaluate the implied prepayment speeds and duration of these securities to gauge their sensitivity to interest rate changes.

Hypothetical Example

Imagine an investor, Sarah, is considering purchasing Fannie Mae securities. She finds a security backed by a pool of 1,000 30-year fixed-rate mortgages, each with an original principal balance of $250,000 and an average interest rate of 4.5%. The total outstanding principal balance of the pool is $250 million.

Sarah understands that while Fannie Mae guarantees the principal and interest payments, the actual timing of these payments can vary. If interest rates drop to 3.5%, many homeowners in the pool might refinance their mortgages. This would cause Sarah to receive her principal back earlier than anticipated. For example, if 10% of the homeowners prepay their mortgages in a given year, $25 million (10% of $250 million) of principal would be returned to the investors, plus any scheduled interest. Sarah would then need to reinvest this $25 million at the new, lower market rate.

Conversely, if interest rates rise to 5.5%, fewer homeowners would refinance. This would mean Sarah receives her principal payments more slowly, extending the life of her investment and locking her into a 4.5% yield while new investments are offering higher returns. This illustrates the interplay of prepayment risk and extension risk that investors consider when evaluating Fannie Mae and Freddie Mac securities.

Practical Applications

Fannie Mae and Freddie Mac securities are widely used in the financial markets for various purposes:

• Portfolio Diversification: Institutional investors, such as pension funds, insurance companies, and mutual funds, incorporate these securities into their portfolios to achieve diversification and generate stable income streams. Their relatively low credit risk makes them attractive for conservative portfolios.
• Interest Rate Hedging: Some investors use Fannie Mae and Freddie Mac securities to manage their exposure to interest rate fluctuations. While they carry prepayment risk, their cash flows are directly tied to mortgage interest rates, making them useful tools for certain hedging strategies.
• Federal Reserve Operations: The Federal Reserve often buys and sells Fannie Mae and Freddie Mac securities as part of its open market operations to influence interest rates and provide liquidity to the financial system. This makes them a critical component of U.S. monetary policy. Federal Reserve
• Residential Mortgage Lending: By purchasing mortgages from originators, Fannie Mae and Freddie Mac provide a continuous source of funding, which in turn allows banks and other lenders to offer more mortgages to homebuyers. This mechanism supports homeownership and the broader housing market.¹⁵, ¹⁶, ¹⁷

Limitations and Criticisms

Despite their vital role in the U.S. housing finance system, Fannie Mae and Freddie Mac securities, and the GSEs themselves, have faced significant limitations and criticisms:

• Implicit Government Guarantee: A primary criticism stems from the implicit government guarantee of their debt. While not explicitly guaranteed by the U.S. government, the market historically perceived that the government would intervene to prevent their failure, as occurred during the 2008 financial crisis. This perception allowed them to borrow at lower rates than purely private entities, creating a moral hazard and shifting potential losses to taxpayers.¹⁴
• Systemic Risk: The sheer size and interconnectedness of Fannie Mae and Freddie Mac within the financial system mean their distress could pose systemic risk to the broader economy. Their conservatorship since 2008 highlights this vulnerability.¹³
• Market Distortion: Critics argue that the GSEs' presence distorts the housing market by crowding out private sector participation and influencing mortgage underwriting standards.¹¹, ¹² The ongoing debate about their conservatorship and the future of housing finance reform often centers on the extent to which private capital should assume more risk.¹⁰
• Affordable Housing Mandates: While intended to support affordable housing, some argue that the GSEs' affordable housing goals can incentivize them to acquire riskier mortgages, potentially undermining financial stability.⁹

Ongoing efforts to reform Fannie Mae and Freddie Mac aim to address these criticisms by reducing taxpayer exposure and increasing the role of private capital in the mortgage market.⁸

Fannie Mae and Freddie Mac Securities vs. Ginnie Mae Securities

While both Fannie Mae and Freddie Mac securities are types of mortgage-backed securities, they are often compared with and distinguished from Ginnie Mae securities. The key differences lie in their issuer, the type of underlying mortgages, and the nature of their government backing.

Understanding these distinctions is crucial for investors assessing the risk and return characteristics of different MBS.

FAQs

Are Fannie Mae and Freddie Mac securities guaranteed by the U.S. government?

Fannie Mae and Freddie Mac securities carry an implicit government guarantee. While not explicitly backed by the "full faith and credit" of the U.S. government, the market has historically assumed, and the 2008 conservatorship demonstrated, that the government would intervene to prevent their failure. Ginnie Mae securities, in contrast, are explicitly backed by the U.S. government.

##⁷# How do Fannie Mae and Freddie Mac securities affect mortgage rates?
By purchasing mortgages from lenders, Fannie Mae and Freddie Mac provide a consistent source of funds, increasing the supply of money available for mortgage lending. This increased liquidity helps to keep mortgage rates lower and more stable than they might otherwise be.

##⁴, ⁵, ⁶# Can individual investors buy Fannie Mae and Freddie Mac securities?
Yes, individual investors can buy Fannie Mae and Freddie Mac securities, typically through brokerage accounts. They are often available as part of mutual funds or exchange-traded funds (ETFs) that specialize in fixed-income or mortgage-backed securities, providing a more diversified and accessible way to invest.

What happened to Fannie Mae and Freddie Mac during the 2008 financial crisis?

During the 2008 financial crisis, Fannie Mae and Freddie Mac faced severe financial distress due to significant losses on their mortgage portfolios, which included riskier loans. To prevent their collapse and stabilize the housing market, the U.S. government placed both entities into conservatorship under the Federal Housing Finance Agency (FHFA). They received substantial financial assistance from the U.S. Treasury.

##¹, ², ³# What are the main risks associated with Fannie Mae and Freddie Mac securities?
The primary risks associated with Fannie Mae and Freddie Mac securities are prepayment risk and extension risk. Prepayment risk arises when homeowners refinance their mortgages due to falling interest rates, returning principal to investors sooner than expected. Extension risk occurs when rising interest rates slow down prepayments, making investors hold lower-yielding securities for longer. While credit risk is low due to the implicit government guarantee, these interest rate-related risks are significant. prepayment risk