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How Fannie Mae and Freddie Mac Guarantees Work In Brief

Anthony Randazzo
October 19, 2011, 3:05pm

Sometimes you don't want all the details on how government funded guarantee programs work. Sometimes you do. For those interested (welcome Reason.com readers), here is a very brief summary of the way that Fannie Mae and Freddie Mac are continuing to bail out mortgage investors through their guarantee programs:

When you get a mortgage, the rights to your loan payments are typically sold to a secondary source. There is a lot of debate over whether the originator of the loan should keep some of the risk, but currently they can make a loan, sell it, and basically be done with it unless they have lied about its contents and are forced to buy it back down the road.

So the mortgage is sold to the secondary market, likely Fannie Mae or Freddie Mac. In fact, the GSEs and FHA bought or guaranteed 95% of all new mortgages in fiscal year 2011! Mind blowing numbers compared to when 40% market share was seen as high in the early 2000s. 

The GSEs then take your loan and put it in a package with other loans they buy and sell rights to the mortgage payments in that package (a mortgage-backed security). The investor is buying rights to part of the principal and/or interest payments, depending on the structure of the deal, on your and many other mortgages. 

In addition, the investor pays a small percentage to Fannie or Freddie as a fee in exchange for a guarantee that they will get paid even if the borrowers stop paying their principal and interest. If you, the borrower, are unable to make a mortgage payment and default on your mortgage, Fannie Mae or Freddie Mac will send a payment to the investor anyway so they do not fully lose out on their purchase of a portion of the mortgage package (the MBS). It is like paying for insurance on a car—if you get in a wreck the insurance company will ensure you get access to another car with some kind of coverage. 

Here is the catch, though, Fannie and Freddie do not have enough money to cover all the missed payments on mortgages that they have guaranteed. Just like AIG, which ran out of money to pay its CDS insurance contracts and needed government money to keep from going bankrupt, so to is the government giving Fannie and Freddie money every quarter so that they can make all their guarantee payments. Too many borrowers have stopped paying their mortgages and the losses are too high for the GSEs to stay solvent. That is why almost every quarter Fannie and Freddie ask for money from Treasury to cover their losses. Here are the current bailout numbers

And those numbers should be going up again next month. The Congressional Budget Office recently estimated that we are likely to see $51 billion more losses for the GSEs over the next 10 years. 

Not only are taxpayers bailing out the GSEs, but they are bailing out the mortgage investors who paid the GSEs for insurance in the first place. That means the financial industry. If Fannie and Freddie had been allowed to fail or had been put through the receivership process, these investors would not be getting what they do now. They made a bet that Fannie would be around to cover their investment, but in a free market world their bet was wrong. Unfortunately, the market wasn't allowed to work and the gamble that taxpayer money would back up a failed Fannie or Freddie turned out to be right. 

If that makes you upset, it should. That is where Occupy Wall Street anger should be focused. And the rage should be targeted at Washington for not dealing with the problem and letting this continue to happen.


Anthony Randazzo is Director of Economic Research


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