Fannie Mae's Mortgage Guarantee: How It Works

The Federal National Mortgage Association, commonly known as Fannie Mae, is a government-sponsored enterprise that plays a crucial role in the US mortgage market. Established to ensure capital liquidity and affordable mortgage loans for low- to middle-income individuals, Fannie Mae purchases mortgages and securitises them into mortgage-backed securities (MBS). By guaranteeing the timely payment of principal and interest on these MBS, Fannie Mae reduces investor risk and increases marketability. This guarantee is backed by its own financial health rather than government funds. In doing so, Fannie Mae has become integral to the US mortgage market, owning or guaranteeing about half of the nation's $12 trillion mortgage market as of 2008.

The role of Fannie Mae

The Federal National Mortgage Association, commonly known as Fannie Mae, is a government-sponsored enterprise (GSE) that was established to maintain capital liquidity and ensure that low- to middle-income individuals can purchase homes with affordable mortgage loans. Fannie Mae creates liquidity for lenders by investing in the mortgage market, allowing them to underwrite more mortgages. The mortgages it purchases and guarantees must meet strict criteria, such as loan limits for conventional loans.

Fannie Mae plays a crucial role in the mortgage market by purchasing mortgages on the secondary market and pooling them to create mortgage-backed securities (MBS). These MBS are then sold to institutional investors, such as insurance companies and pension funds. Fannie Mae guarantees the timely payment of principal and interest on these MBS, reducing investor risk and increasing marketability. This guarantee is backed by its financial health rather than government funds. By providing this guarantee, Fannie Mae attracts investors who might not otherwise invest in mortgages, increasing the pool of funds available for housing.

Fannie Mae also has its own portfolio, known as a retained portfolio, which invests in MBS from itself and other institutions. To fund this portfolio, Fannie Mae issues debt called agency debt. Additionally, Fannie Mae earns a significant portion of its income from guaranty fees received for assuming the credit risk on mortgage loans underlying its MBS and those held in its retained portfolio. These guaranty fees provide compensation for the risk assumed by Fannie Mae, even in the event of borrower default.

Fannie Mae, along with Freddie Mac, has played a significant role in the U.S. mortgage market, owning or guaranteeing about half of the nation's $12 trillion mortgage market as of 2008. Their activities have a global impact, with bonds held by entities ranging from the Chinese government to retirement funds. The enterprises provide an implicit guarantee of their financial stability, which has allowed them to benefit from lower borrowing costs. However, this implicit guarantee was tested during the 2008 financial crisis, which led to a government bailout and conservatorship.

How does Fannie Mae guarantee MBS payments?

Fannie Mae is a government-sponsored enterprise that guarantees mortgages to make them available to low- and moderate-income borrowers. It acquires mortgage loans for inclusion in Mortgage-Backed Securities (MBS). MBS are secured by a beneficial ownership interest in either a single mortgage loan or a pool of mortgage loans secured by residential properties.

Fannie Mae's MBS program issues and sells MBS that represent fractional, undivided, beneficial ownership interests in a distinct pool of mortgages. The MBS are backed by mortgages that lenders sell to Fannie Mae. The mortgages purchased and guaranteed by Fannie Mae must meet strict criteria. For example, the limit for a conventional loan for a single-family home in 2023 is $726,200 for most states and the District of Columbia and Puerto Rico. For certain states and territories with high housing costs, such as Hawaii, Alaska, Guam, and the US Virgin Islands, the limit is set at $1,089,300.

Fannie Mae guarantees the timely payment of the principal and interest paid on loans. This guarantee reduces investor risk and increases the marketability of MBS. To ensure this, Fannie Mae uses prudent underwriting guidelines to evaluate the credit quality of the loans it guarantees to minimize losses to its investors.

Fannie Mae MBS can be combined with other Fannie Mae mortgage-related securities to create a single structured transaction security. These include Supers, Megas, SMBS, and REMICs.

The impact of the subprime mortgage crisis

The subprime mortgage crisis, which occurred between 2007 and 2010, had a significant impact on the global economy and contributed to the 2007–2008 global financial crisis. Here are some key impacts of the subprime mortgage crisis:

• Economic Recession: The crisis led to a severe economic recession, resulting in job losses and business bankruptcies. Millions of people lost their jobs, and many businesses went bankrupt, requiring the intervention of the U.S. government with measures like the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA) to stabilize the financial system.
• Housing Market Collapse: The crisis caused a collapse in the housing market, leading to a downward spiral in house prices. As borrowers struggled to make loan payments, they either sold their homes or faced foreclosure, increasing the number of homes being sold into an already weakened housing market. This resulted in sliding house prices, further reducing the demand for homes.
• Financial Institution Losses: Major investment banks and other financial institutions suffered significant financial losses due to their exposure to subprime mortgage-backed securities and collateralized debt obligations. The collapse of the housing bubble and the subsequent decline in the value of these securities led to substantial losses for these institutions.
• Government Intervention: The crisis led to the seizure of government-sponsored enterprises, such as Fannie Mae and Freddie Mac, by the federal government in 2008. These enterprises had issued debt to fund purchases of subprime mortgage-backed securities, which later fell in value, resulting in substantial losses.
• Lending and Credit Tightening: In the aftermath of the crisis, lenders made qualifying for mortgages more difficult, even for relatively low-risk applicants. This depressed housing demand further and reduced the ability of financial firms to lend money, impacting the overall economy.
• Impact on Investors: The crisis had a significant impact on investors, particularly those holding mortgage-backed securities (MBS). As borrowers defaulted on their loans, lenders struggled to pass through mortgage payments to MBS investors, causing financial distress. The need for MBS guarantees to maintain investor confidence and liquidity became evident.

The government's role

The US government has played a significant role in the operations of Fannie Mae, a government-sponsored enterprise. Notably, during the 2008 US housing crisis, the government considered taking over Fannie Mae and its counterpart Freddie Mac due to their worsening financial situations. This consideration arose from the fact that both enterprises owned or guaranteed a substantial proportion of all home loans in the country, and their collapse would have made mortgages harder to obtain and significantly more expensive.

Fannie Mae and Freddie Mac are not government agencies, but they are subject to government directives. For instance, in 2011, Congress directed the Federal Housing Finance Agency (FHFA) to increase the guarantee fees charged by these enterprises to lenders on single-family mortgages. The FHFA has overseen the two firms since they went into conservatorship in 2008 and has reviewed their policies for guarantee fees. The US government also bailed out and put the enterprises into conservatorship during the 2008 subprime mortgage crisis.

Despite not being a government agency, Fannie Mae has an "implicit guarantee" from the government. This perception suggests that the government would not allow such an important institution to fail or default on its debt. This implicit guarantee was tested during the subprime mortgage crisis, and the government's bailout reinforced this perception.

Fannie Mae plays a crucial role in the mortgage market by creating more liquidity for lenders, such as banks, thrifts, and credit unions, enabling them to underwrite more mortgages. It purchases mortgages on the secondary market, pools them into packages of mortgage-backed securities (MBS), and guarantees timely payments of principal and interest on these securities. This guarantee is backed by its financial health and reduces investor risk, attracting investors who might not otherwise invest in mortgages.

Fannie Mae also focuses on loan modifications to prevent bank foreclosures and assist homeowners in financial distress. It modifies existing mortgage conditions, such as reducing the loan interest rate or extending the loan term, to make repayments more manageable. These efforts align with the Housing and Community Development Act of 1992, which mandated that Fannie Mae and Freddie Mac facilitate affordable housing for low- and moderate-income families while maintaining financial stability.

The future of Fannie Mae

The Federal Housing Finance Agency (FHFA) has set new affordable housing goals for Fannie Mae and Freddie Mac for the years 2025 to 2027. These goals are intended to support equitable housing access for low-income families and families in low-income areas. The FHFA has also established new "measurement buffers" to determine if an enterprise that misses certain single-family housing goals during the 2025-2027 cycle must develop a housing plan.

Fannie Mae has been working towards creating a more sustainable and inclusive future for housing. In 2021, the organisation focused on identifying challenges faced by Black borrowers and shared its findings with the industry and the public. It also launched the Your Own Story campaign, which provided homebuyers with accessible, interactive information on how to achieve sustainable homeownership. In the same year, Fannie Mae launched RefiNow™, a product that aimed to help low-income homeowners with mortgages take advantage of the low-interest-rate environment and reduce their mortgage costs.

Fannie Mae has also been working to support holistic housing by partnering with organisations in sectors adjacent to housing, such as employment, education, and health. Through these partnerships, the organisation aims to explore innovative ways to support stable and affordable housing options.

In terms of the broader housing finance market, there have been questions about the future role of Fannie Mae and similar enterprises in supporting the recovering housing market. While there have been discussions about reducing the federal government's involvement in these enterprises, the new director of the FHFA, Bill Pulte, has stated that there are no plans to lower the conforming loan limit for Fannie Mae and Freddie Mac.

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