Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

CASE STUDY :
Federal Home Loan Mortgage Corporation (aka FREDDIE MAE )
Federal National Mortgage Association (aka FANNIE MAC)

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

EVENTS
Fannie Mae was born in 1938 on the back of Franklin

Roosevelts New Deal to facilitate liquidity in the mortgage

market, with explicit US government backing
In 1968 Fannie Mae was converted in a GSE (government

sponsored enterprise) with implicit government backing

In 1970, Freddie Mac was created to compete with Fannie

Mae, and between them they facilitated the securitization of

the largest mortgage market in the world
In 1977, the business model for both was compromised by

politicians insisting on more lending in poorer areas without

appropriate the increased risk
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

EVENTS
In 1999, politicians succeeded in having the credit and

collateral requirements for both Fannie and Freddie eased to

allow more mortgages for more, lower income, families

In 2000, some tightening of the rules to exclude some risky,

high-cost lending from the securitization program

In 2003, oversight of Fannie and Freddie comes under US

Department of Treasury Control, and new US government

funds were made available for mortgage down-payment and
closing costs

In 2004, the restrictions of 2000 were dropped and high-risk

loans could be securitized again

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

IMPLICIT GOVERNMENT GUARANTEE

Selling of debt at lower interest rates than private rivals.
Access to a virtually unlimited source of cheap cash. Risk-

averse investors, including pension funds and foreign

governments, seeking above Treasury yields flocked into
the GSE bonds.
Myriad of competitive advantages over the private

players in the secondary mortgage market

Exemption

from federal securities laws, saving

registration fees for issuing securities and avoiding SEC
disclosure requirements
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PRM PREPARATION - EXAM IV

IMPLICIT GOVERNMENT GUARANTEE

Exemption from most state and local taxes
Federal law enables fiduciaries to invest in Fannie and

Freddie obligations as if they were government securities

Money market funds diversification requirements do not

apply to Fannie and Freddie obligations.

Exemption from the three percent capital/asset ratio

requirement of the FDIC Bank Holding Company Act that

governs the solvency of financial institutions

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

HOUSING AND COMMUNITY DEVELOPMENT ACT

Prior to the 1992 Act :
Political pressures, primarily from Republicans and from
free-market economists, to revoke their federal charters
and privatize the firms as for-profit state corporations.
As ordinary corporations the GSEs would lose the many

perks associated with the federal charter, particularly the

implicit federal government guarantee
To save their federal charter the GSEs convinced Congress

in the 1992 Act to include a mandate for the affordable

housing goals
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

HOUSING AND COMMUNITY DEVELOPMENT ACT

Obligation to facilitate the financing of affordable housing

for low- and moderate-income families

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.
To meet the goals , Fannie and Freddie and the banks

relaxed their lending standards

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

LOOSENING OF THE UNDERWRITING STANDARDS

The demand-side pressure for mortgage loans had a feed-

back loop effect on housing prices, pushing them up

artificially.
This in turn had an inherently negative effect on the

quality of the loans themselves.

homes, was inherently overvalued

Loan collateral, the

The demand-side appetite put pressure on the primary

market to loosen underwriting standards

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

LOOSENING OF THE UNDERWRITING STANDARDS

Originating banks lowered lending standards for CRA

loans, counting the loans towards their affordable

housing goals
Close to fifty percent of the total CRA originations from

2000 to 2007 to Fannie and Freddie, which used the loans

to meet their affordable housing goals as well.
Fannie and Freddie bought Private Label Securities

backed by subprime loans with CRA originations to count

them towards their affordable housing goals.
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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LOOSENING OF THE UNDERWRITING STANDARDS

Lower lending standards were extended to non CRA loans

as well as the proliferation of liars loans.

How all that had been made possible?
In 1999, politicians succeeded in having the credit and

collateral requirements for both Fannie and Freddie

eased to allow more mortgages for more, lower income,
families
In 2004, the restrictions of 2000 set to exclude some high

risks loans from securitization were dropped

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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A DISASTER WAITING TO HAPPEN

Excessive leverage: by the end of 2007, Fannies and

Freddies combined leverage ratio, including loans they

owned and guaranteed, stood at 75 to 1.
No effective oversight controls over Fannie and Freddie

management by shareholders, debt holders or regulatory

authorities
Management was subject to heavy political pressure to

grow as fast and as quickly as it could in the riskiest

corners of the new market
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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A DISASTER WAITING TO HAPPEN

Fannie and Freddie management had access to cheap

money to invest in a rapidly growing market that

generated easy returns

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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THE COLLAPSE
In 2007 the subprime mortgage crisis revealed itself.
An increasing number of borrowers in the subprime
market could not meet their mortgage payments.
Home foreclosures increased and home prices declined

as foreclosures added a large inventory of homes to the

market.
Tighter lending standards made it more difficult for

borrowers to get mortgages.

The depreciation in home prices led to growing losses for

Fannie and Freddie, which at the time backed the

majority of residential mortgages.
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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THE COLLAPSE

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PRM PREPARATION - EXAM IV

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THE LOSSES
Fannie and Freddie had suffered heavy write-downs on
Their securities portfolio of both private-label mortgagebacked securities (PLMBS) and their own and each others
securities
Their whole loan portfolio, and their loan guarantees.
***
The combined losses at Fannie and Freddie from July
2007 to July 2009, totalled $165 billion.
The largest losses stemmed principally from purchases

and guarantees of mortgages originated in 2006 and

2007.
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PRM PREPARATION - EXAM IV

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RISKS INCURRED
Credit Risk the clear lack of pricing risk into

securitization and lending decisions

Market and Liquidity Risk
Model Risk computational and stress testing models on

the mortgage pools were clearly unable to cope with the

sophistication and complexity of the underlying lending
products being sold to sub-prime borrowers
Operational Risk politicians, and financial risk

management they dont mix well.

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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RISKS INCURRED
Regulatory Governance Risk the failure by the

regulators to identify, and remedy, the build-up of credit

exposure and losses inherent in such a complex
infrastructure
Moral Risk the blurring of ownership, accountability

and ultimate responsibility, for any GSE

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PRM PREPARATION - EXAM IV

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POTENTIAL MITIGATIONS
Implied or explicit government guarantees can prove to

be disastrously expensive and in many instances, create a

systemic risk.
Strict loan approval procedures and standards, and best-

practice approaches to tracking credit risk concentrations

and deterioration
Politicians must ensure that they are well educated and

informed about the economic reality and risk factors

underlying key business, economic, and political decisions
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PRM PREPARATION - EXAM IV

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