The Great Collapse Part 3: Fannie, Freddie and the Gang

So... Where were we? Ah yes. Fannie. Government trying to increase home-ownership and ease the limitations of a fragmented banking system. Right, on with the show...


Fannie Mae was originally owned outright by the government but was eventually spun off into a sort of quasi-governmental limbo known as "government sponsored entity". (This, too, will feature heavily in later parts of the story...) What being a GSE meant is that although it was technically a separate and private organization, because it had been founded by the government and was theoretically doing things the government wanted done it was assumed by most people that it was implicitly backed by the government. This allowed it to borrow money using the government's good credit.

(The U.S. Government is considered the safest thing to lend money to in the world, ever. The rate they borrow money at is used as the "risk free rate" in financial calculations. This was the result of a long history of always, always paying off our debts that dates back all the way to the very founding of the country when the government, changing from the Articles of Confederation to our current constitutional order decided to honor the obligations of the previous government. Well over 200 years of never missing a payment puts you in very rarefied company, financially speaking. Anyways...)

So. What was Fannie established to do? Simple, it was established to buy mortgages from the various little banks to get them off the banks books. Once it bought a mortgage from a bank, the bank, in effect, had just been repaid and could go about putting out another mortgage, thereby dramatically increasing the availability of mortgages.

How did it do this? Well, originally it did it straight out with the government's money. Later it would do it with borrowed money. Ultimately, it would sell these mortgages to investors. The problem, from an investor's point of view, with buying a mortgage is the risk that the person stops paying the mortgage. Or pays it off early with a refinance or the like. When an investor is buying some form of debt, they like to know that the stream of payments is going to be there.

So what Fannie would do is kind of insure the stream of payments. First, they were buying a huge amount of mortgages, the vast majority of which would never have any problems. So when Fannie sold a pool of mortgages to investors, they would kind of stay as the middle men, taking in the payments, skimming some off to use as a reserve for the payments that don't get made, and giving the rest, as agreed, to the investors.

This is a sort of proto-form of mortgage securitization, which will be the fun and exciting topic of our next part.

All-in-all this government started buying-of-mortgages scheme was probably a good thing at the time because capital markets had not yet developed the kind of sophistication needed to provide that kind of service on their own.

Rushing though the history a bit, the government also founded Freddie Mac to do largely the same thing, on the theory that it was better to have some competition in the mortgage-buying games, to keep things relatively efficient.

So for a long time this was basically the state of mortgages. Small regional bank gives you a mortgage, they sell it to Fannie or Freddie and find somebody else to give a mortgage to. Fannie or Freddie sell pool it together, sell it off to investors and go buy some more mortgages. Wash, rinse, repeat.

Relatively simple. But then in the 80's some exciting stuff happens... Solomon Brothers (which was then an esteemed bond-trading house on Wall Street) invents mortgage securitization. What the hell is mortgage securitization? It is, finally, the fundamental reason for shit-storm in which we find ourselves. This does not mean it was a bad thing.

But it is a complicated thing so I'll give it it's own part, stay tuned for Part 4 of our little story...