10. Real Estate Lending - Part 1
Who are Fannie and Freddie and why are they important? A history on who they are and why they exist.
Were you around in 2008? I bet you’ve heard of Fannie Mae, Freddie Mac & possibly Ginnie Mae? Ever wondered who or what these entities are? Maybe you have. Have you ever wondered what the mortgage market looked like in the early 1900s? Or how you got a mortgage back then? I bet you haven’t! In the early 1900s home mortgages were often short term with a balloon payment required at the end of the term. In the great depression, up to 25% of all mortgages in the country defaulted with those homes being taken back by the banks. Ouch. Why were those home loans short term and so different from the 30 year loans that are the industry standard now? Well, if you’re a small regional bank with limited assets you’d run out of money fast if you held onto each mortgage you issued and slowly got your capital back over a 30 year period. As a result, they wanted their money back faster so they could lend it out again and introduced a shorter term.
Luckily, the federal government stepped in with a plan to create a secondary market of companies that will purchase those mortgages from the small regional banks (or anyone really) so they could get their capital back and lend it out to the next person wanting a mortgage.
That’s essentially what happened in 1938 when congress, yes-Congress, created the Federal National Mortgage Association. Colloquially known as Fannie Mae. They were a product of the great depression and the New Deal. Their existence guarantees liquidity in the secondary mortgage market by buying mortgages from the lender who issued them to you. They then package those mortgages together into securities that investors can buy. You can buy stock in the company as well. If you’re curious, look up the ticker FNMA. In 2019 Fannie Mae had 3.5 TRILLION in assets so they’re a very large company!
Freddie Mac is actually the Federal Home Loan Mortgage Corporation. They were created in 1970 to create more liquidity in the secondary mortgage market.. They also buy mortgages on the secondary market, package them into securities, and guarantee their return to the investors. You can also buy stock in the company for about the same price as Fannie Mae. In 2019 they had 2 trillion in assets trading under the ticker FMCC.
Ginnie Mae, or the Government National Mortgage Association, Is an offshoot of Fannie Mae created in 1968. They only deal with VA, FHA, Indian affairs, and rural development loans. They also offer a Mortgage Backed Security product. Of the three companies mentioned, only Ginnie Mae is wholly owned by the government. While they don’t buy up mortgages like the other two do, they are the only ones that can claim their product is backed by the full faith and credit of the US government.
If you’re curious what we mean by a secondary market, think of Craigslist. Let’s say you buy a brand new Toyota Corolla from the dealer. After 10 years, you list it on craigslist and sell it to a guy from the internet. Craiglist is the secondary market making your sale of the used corolla possible. For that matter, Auto Trader, the newspaper for sale section, or a for sale sign on your car all act as the secondary market for used automobiles. You’ll also need a willing buyer, of course!
So what are these mortgage backed securities? Well, after Fannie or Freddie buys your loan, they’ll then package it along with many others into a Mortgage Backed Security and then sell those to investors. But what happens if you stop paying your mortgage? Well, that’s bad for you but not the investor. Each of these three companies guarantees to the investor that the principal and interest portions of your mortgage payment will be made on time. That makes the investors happy and secure that they won’t lose their money. Generally, these investments are thought of as a safe bet. What happens to Fannie or Freddie if you don’t pay your mortgage? Since we just told you that they guarantee to the investor that you’ll pay your mortgage, those funds you didn’t pay have to come from somewhere. Well, now we’re delving into the world of wall street derivatives with something called a credit default swap. Think of it like an insurance policy that Fannie buys in case you don’t pay. Sound complex? Well, it is. If you want to understand this better go watch the movie “The Big Short” and you’ll have a much better idea of what happened during the housing crash in 2008.
Fannie and Freddie aren’t the only companies that can buy loans on the secondary market. Anyone with the capital can do that. There are real estate investors who have carved out a niche for themselves by investing in mortgages, also called “notes.” Any promise to pay can be bought and sold. This includes mortgages, car loans, medical bills, or that cell phone bill you didn’t pay 10 years ago. If you’ve had a mortgage for any length of time you’ve probably had this experience yourself.
This has been part one in a multi part series on Loans. In the next episode, we’ll talk about some terms you need to know and what kind of loans you as an investor will want to know about.
La fin.