Chapter 1

Freddie Mac Maintains a Strong Public Focus

Most homebuyers are familiar with a number of institutions that enable them to obtain mortgages and buy the homes of their dreams. These include mortgage companies, commercial banks and thrift institutions as well as private mortgage insurers and government agencies such as FHA and VA. Following origination, many borrowers are informed that another company, a mortgage servicer, will handle their monthly payments.

With all these different players, many Americans may be unsure how Freddie Mac and Fannie Mae fit into the homebuying process. Although largely invisible to homebuyers, the daily operations of these two companies ensure a continuous supply of low-cost mortgages, benefiting American families every day.

A. Linchpins of a Flourishing Housing Finance System

The U.S. housing finance system consists of a primary mortgage market and a secondary mortgage market that work to bring homebuyers and investors together. Exhibit 1 shows the basic elements of this process. In the primary market, borrowers obtain mortgage funds from banks, thrifts, credit unions or mortgage companies. These lenders, in turn, obtain mortgage funds in a variety of ways, often through deposits or by selling mortgages in the secondary mortgage market. A variety of products are available to borrowers, including fixed- and adjustable-rate mortgages. Interest rates on ARMs adjust periodically based on an index, such as the yield on Treasury securities. The amount of the payment change at any one time is capped.

The secondary market encompasses institutions engaged in buying and selling mortgages and mortgage-related instruments. Freddie Mac and Fannie Mae have a singular focus--making a secondary market for conventional home mortgages. In purchasing mortgages from lenders, they channel funds back to the primary market and to new homebuyers. To finance their activities, the companies issue debt or group individual mortgages into mortgage pools to create securities, which are sold to investors. These activities replenish the funds available to finance homeownership and rental housing. By connecting Main Street with Wall Street, or individual homebuyers with the ultimate mortgage investors, Freddie Mac and Fannie Mae serve as the linchpins of a flourishing housing finance system. Their mortgage purchase and financing activities ensure a stable flow of low-cost mortgage funds.

Typically, the sale of a loan into the secondary market is invisible to the homeowner. The borrower sends the monthly payment to the original lender or a mortgage servicer that manages the payments, including insurance and other escrow accounts, in return for a fee. The majority of the payment is remitted by the servicer to the loan purchaser, often Freddie Mac or Fannie Mae. Freddie Mac and Fannie Mae, in turn, retain a fee for administering the payments and insuring the risk that borrowers might default. Then the companies remit the majority of the proceeds to investors who hold their debt or mortgage-backed securities.

Freddie Mac and Fannie Mae supply an essential ingredient for the smooth functioning of the mortgage market: securities that appeal to a broad range of investors. Prized for their high credit quality and the ability to be bought and sold as needed, mortgage-backed securities guaranteed by Freddie Mac and Fannie Mae are held by depository institutions, life insurance companies, pension and mutual funds and foreign investors. The debt securities issued by the two companies also are held by a broad group of investors. Other firms issue mortgage-backed securities known as private-label securities, but these are less appealing to investors because of their lower credit quality and higher costs to evaluate and trade.

B. Unique Institutions with a Unique Role

Freddie Mac and Fannie Mae are uniquely structured to act as linchpins of the housing finance system. Freddie Mac and Fannie Mae are not government agencies; no taxpayer dollars are used to fund their operations. They are not banks or thrifts, and they do not benefit from federal deposit insurance. Freddie Mac and Fannie Mae are privately owned institutions that are congressionally chartered, that is, they were created by--and their powers, duties and limitations are set out in--statutes passed by Congress.

The congressional charters restrict Freddie Mac and Fannie Mae to specific purposes and provide specific tools enabling them to accomplish those purposes. Although the two charters have been modified over the years, the public purpose of Freddie Mac and Fannie Mae--to facilitate the steady flow of low-cost mortgage funds--has remained unchanged.

1. Public Focus

The charters of Freddie Mac and Fannie Mae contain several restrictions that ensure that they maintain a singular focus. First, the scope of business for each company is limited to the residential mortgage market. This contrasts with other corporations, which may enter (or exit) any lawful line of business. Freddie Mac and Fannie Mae, however, may not enter into unrelated lines of business nor may they discontinue support for the residential housing market. Today, mortgages are available whenever borrowers need them because Freddie Mac and Fannie Mae participate in this market in all kinds of economic environments. The stability that comes from a single public focus was sorely lacking prior to the creation of the secondary mortgage market.

Second, their charters dictate the type of mortgages that Freddie Mac and Fannie Mae may buy. To be eligible for sale to the two companies, mortgages must be below a specified amount, known as the conforming loan limit. This amount is recomputed each year based on changes in national house prices, as required by the charters. For 1996, the conforming loan limit is $207,000. 1
Another requirement is that mortgages with loan-to-value (LTV) ratios above 80 percent must carry private mortgage insurance or some other form of credit enhancement. That is, mortgages with down payments less than 20 percent require additional protection to offset risk. Further, the charters explicitly state that the types of mortgages purchased by the two companies must be acceptable to private institutional mortgage investors.

Third, Freddie Mac and Fannie Mae are barred from assuming the functions of other housing finance institutions. For example, the companies are prohibited from originating mortgages. Unlike the Federal Home Loan Banks (FHLBs), they are limited in their ability to advance funds using mortgages as collateral.

Fourth, the Department of Housing and Urban Development (HUD) regulates certain aspects of Freddie Mac’s and Fannie Mae’s activities. Each quarter, the two companies must report on their progress toward meeting annual housing goals administered by HUD. One goal stipulates levels of mortgage purchases supporting housing for low- and moderate-income families. A second goal stipulates levels for high-minority and low-income areas. A third goal--the special affordable housing goal--stipulates levels for very-low-income families or low-income families in low-income areas. In addition, HUD approval is required before Freddie Mac and Fannie Mae may implement new programs that differ significantly from existing programs.

Fifth, the government monitors the financial condition of Freddie Mac and Fannie Mae. The two companies are subject to risk-based and minimum capital requirements and annual examinations by OFHEO, whose expenses the two firms fully cover. Failure to maintain sufficient capital could result in severe sanctions, including OFHEO conservatorship of the companies.

2. Charter Tools

To enable Freddie Mac and Fannie Mae to serve their public purposes effectively, Congress also provided specific tools. Recognizing the importance of developing a liquid market for mortgage securities, Congress extended the preferential treatment of U.S. Treasury obligations to the securities of Freddie Mac and Fannie Mae. However, unlike Treasury securities, Freddie Mac and Fannie Mae securities do not carry the “full faith and credit” guarantee of the U.S. government. Further, securities issued by the two companies are exempt from the registration requirements of the Securities and Exchange Commission (SEC) as well as comparable state law requirements. They are fully subject, however, to the anti-fraud provisions of the securities laws designed to protect investors.

The charter exempts the two firms from state and local income taxes, although they do pay state and local real estate taxes and federal income taxes. The state-tax exemption removes an obstacle to development and maintenance of a nationwide secondary mortgage market.

To support the liquidity of Freddie Mac and Fannie Mae obligations, the secretary of the Treasury is authorized, but not required, to purchase up to $2.25 billion of securities from each company. This is not a line of credit that provides the companies access to taxpayer dollars. Instead, this provision was designed to allow the U.S. Treasury to act quickly to support the housing finance system without the necessity of passing legislation. Over time, the dollar amount has become small in relation to the activities of Freddie Mac and Fannie Mae (it has not been increased since 1957).2
However, this provision retains symbolic importance. It helps convey to investors that the government recognizes the continuing national interest in maintaining a stable housing finance system.

3. Private Capital and Market Incentives

The genius of the structure of the two corporations lies in the combination of a congressional charter--with all of its attendant limitations and tools--plus shareholder capital. Freddie Mac’s and Fannie Mae’s stocks are traded on the New York Stock Exchange, and most members of their boards of directors are shareholder-elected.3
The charters require these two privately owned companies to fulfill their public purposes of providing liquidity, promoting stability and supporting targeted borrowers while earning a “reasonable economic return.” 4

For Freddie Mac, building shareholder value and serving public purposes are inextricably linked: One cannot be accomplished without the other. Successfully meeting the needs of customers--including investors, lenders, and ultimately homeowners and renters--generates a return that attracts investors to provide the needed capital. Freddie Mac shareholders earn returns comparable to those for other well managed institutions. For example, in 1995 the average return on equity of the top ten commercial banks was 22 percent, identical to Freddie Mac’s return of 22 percent. 5
Likewise, the top ten well-managed firms, as rated by Fortune, had an average return on equity of 27 percent. 6
Competitive returns attract the capital needed to ensure that funds are continuously available to finance housing and drive down mortgage rates for borrowers.

4. Making the Dream a Reality

The combination of public focus, charter tools and private capital has made the U.S. housing finance system the most stable and efficient in the world. No other system consistently provides low-cost mortgage funds that enable families, with diverse needs and financial capacities, to live in decent homes in neighborhoods of their choice. At the end of 1995, total Freddie Mac and Fannie Mae mortgage holdings--financed by debt and mortgage-backed securities--represented 20 million dwellings, or about 20 percent of the nation’s housing stock.

Currently 65 percent of U.S. households own their homes, and approximately 80 percent of Americans will be homeowners at some point during their lives. Homeownership constitutes a major portion of household wealth and provides broad social benefits. 7
In promulgating regulations for Freddie Mac and Fannie Mae, HUD Secretary Henry Cisneros stated:

Homeownership fosters family responsibility and self-sufficiency, expands housing choice and economic opportunity, and promotes community stability. Ownership also improves access to the larger homes and better neighborhoods particularly needed by families with children.8

Freddie Mac helps put people in homes they can afford and keep. By using the charter tools and harnessing private-market efficiencies, we make the dream of homeownership

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