Freddie Mac

December 2007

Freddie Mac

Freddie Mac - Federal Home Loan Mortgage Corporation

The Federal Home Loan Mortgage Corporation (FHLMC) NYSE: FRE, commonly known as Freddie Mac, is a government-sponsored enterprise (GSE) of the United States Government. As a GSE, it is a stockholder-owned corporation authorized to make loans and loan guarantees. The FHLMC was created in 1970 to expand the secondary market for mortgages in the United States.

Along with other GSEs, Freddie Mac buys mortgages on the secondary mortgage market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures that money continues to be available for new home purchases.

The name “Freddie Mac” is a creative acronym-portmanteau of the company’s full name that has been adopted officially for ease of identification.

Freddie Mac History

From 1938 to 1968, the secondary mortgage market in the United States was monopolized by the Federal National Mortgage Association (Fannie Mae), which had up until then been a government agency. In 1968, to help balance the federal budget, part of Fannie Mae was converted into a private corporation. To provide competition in the secondary mortgage market, and to prevent Fannie Mae from continuing to have a monopoly, Congress chartered Freddie Mac as a private corporation to compete in this same market.

Freddie Mac Business

Freddie Mac’s primary method for making money is by charging a guarantee fee on loans that they have purchased and securitized into Mortgage-backed security bonds. Investors, or purchasers of Freddie Mac MBS, are willing to let Freddie Mac keep this fee in exchange for assuming the credit risk, that is, Freddie Mac’s guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays.

Both Alan Greenspan and Ben Bernanke have spoken publicly in favor of greater regulation of the GSEs, due to the size of their holdings and the widespread perception that they are government backed. Freddie Mac is currently regulated by the U.S. Department of Housing and Urban Development (HUD) and its Office of Federal Housing Enterprise Oversight (OFHEO). The United States House of Representatives recently passed HR 1427 (Federal Housing Finance Reform Act of 2007) which would consolidate oversight for Freddie, Fannie, and the Federal Home Loan Banks into a single regulator.

Conforming Loans

The GSEs are only allowed to buy conforming loans, which limits secondary market competition for non-conforming loans. OFHEO annually sets the limit of the size of a conforming loan based on the October to October changes in mean home price, above which a mortgage is considered a non-conforming jumbo loan. By virtue of the laws of supply and demand, then, it is harder for lenders to sell the non-conforming loans, thus it would cost more to the consumers (typically 1/4 to 1/2 of a percent, but can be more due to credit market conditions). The conforming loan limit is 50 percent higher in high-cost areas such as Alaska, Hawaii, Guam and the US Virgin Islands, and is also higher for 2-4 unit properties on a graduating scale.

Explicit Guarantees

The FHLMC states, “securities, including any interest…, are not guaranteed by, and are not debts or obligations of, the United States or any agency or instrumentality of the United States other than Freddie Mac.” The FHLMC and FHLMC securities are not funded or protected by the US Government. FHLMC securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in public communications issued by the FHLMC.

Implicit Guarantees

There is a wide perception that FHLMC securities are backed by some sort of implied federal guarantee, and a majority of investors believe that the government would prevent a disastrous default. Vernon L. Smith, 2002 Nobel Laureate in economics, has called FHLMC and FNMA “implicitly taxpayer-backed agencies.” The Economist has referred to “[t]he implicit government guarantee” of FHLMC and FNMA.

Federal Subsidies

The FHLMC receives no direct federal government aid. However, the corporation and the securities it issues are thought to benefit from government subsidies. The Congressional Budget Office writes, “there have been no federal appropriations for cash payments or guarantee subsidies. But in the place of federal funds the government provides considerable unpriced benefits to the enterprises… Government-sponsored enterprises are costly to the government and taxpayers… the benefit is currently worth $6.5 billion annually.”

Freddie Mac’s Role Within the Secondary Mortgage Market

As a leader in the secondary mortgage market, Freddie Mac helps make homeownership a reality for millions of people in America every year. Here’s how the secondary mortgage market works.

Putting the Process in Motion

Homebuyers apply for mortgages from primary market mortgage lenders such as banks, thrifts (which include savings and loan associations and savings banks), mortgage companies, credit unions, and online lenders.

The primary market mortgage lender evaluates the homebuyer’s ability to repay the mortgage, and if the lender’s criteria are met, arrangements are made to make the loan. The transaction between the lender and the borrower culminates in what is called “the closing.” By signing the closing documents, the lender agrees to fund the purchase of the home and the homebuyer agrees to pay the mortgage as negotiated. Once the loan is closed, the funds are transferred from the primary lender to the property seller.

Entering the Secondary Mortgage Market

After the closing, the primary lender may either hold the mortgage in its portfolio (along with other loans it has made) or sell it in the secondary mortgage market.

When primary mortgage lenders sell loans in the secondary market, they generally sell them as loans to an institution like Freddie Mac. They then use the proceeds of the sale to make new loans to other homebuyers in their community.

Freddie Mac is one of the largest investors in mortgages. As a major player in the secondary mortgage market, Freddie Mac:

_ buy mortgages that meet our underwriting and product standards

_ package those loans into securities

_ sell the securities to investors on Wall Street

Making Homeownership Possible

The mortgages we purchase are bundled or pooled together as mortgage-backed securities (MBS). We guarantee timely payment of principal and interest to MBS investors and finance these purchases by issuing debt and mortgage securities. Investors value our guarantee and the homogeneous quality and liquidity of MBS over individual mortgages. Because of these attributes, investors in MBS are willing to accept a slightly lower yield as the funds pass through to them from us.

In addition, we provide more funds to the primary mortgage market through portfolio investment. By investing in mortgages, we attract funds for primary market mortgage lenders from investors who would not otherwise invest in the U.S. residential mortgage market, or who might be averse to prepayment risk. Find out more about these two kinds of securities.

Freddie Mac uses the funds from sales of these securities sales to purchase more loans from primary lenders. In this way, we are constantly replenishing the pool of funds available for new loans, which allows primary lenders to use the cash they get from us to originate new mortgages. This makes the mortgage process fast, convenient, and affordable.

Secondary Mortgage Market Freddie Mac

About half of all new single-family mortgages originated today are funded in the secondary mortgage market.

Tangible Benefits

The supply of cash the secondary mortgage market makes available to lenders through this process drives down mortgage rates by as much as one-half percent - saving the homeowner with a $150,000 mortgage around $18,000 in interest over the life of a 30-year loan. That savings helps make homeownership affordable for more families and individuals than would be possible without the secondary mortgage market. As a result, homeownership is a reality for many American families, and not just a dream.