Fannie Mae was created in 1936 during the Great Depression to provide a secondary market to encourage greater use of the innovative long-term, fixed-rate, level-payment, fully amortized mortgages that the newly created Federal housing Administration (FHA) was insuring against loss of principal and interest. The exercise was a success, and this type of innovative mortgage became the standard means of financing the postwar housing boom that raised the homeownership rate from 44 percent in 1940 to 69 percent by 2004.
By the 1970s, the basic purpose of the GSEs had shifted to the role of adding more funds to the housing market by connecting prospective homebuyers with major capital markets. To accomplish this goal, the GSEs use their preferred credit rating to borrow in major financial markets and use the funds raised to acquire residential mortgages from brokers and other mortgage originators, earning profits and covering expenses on the difference in the interest rates earned and paid. The GSEs also package mortgages acquired from originators into "pass through" securities that are collateralized with qualified residential mortgages. Payments of principal and interest made by the homeowners are then "passed through" to the investors holding the securities.
Over much of this period, Fannie Mae and the federal government were minor players in the process. By 1965, the homeownership rate had risen to 63 percent, but Fannie Mae and the other sources of federal mortgage credit support accounted for only 6 percent of outstanding residential mortgages. Savings and loan associations, savings and commercial banks, and life insurance companies accounted for most of the rest.
Fannie Mae was restructured as a federally chartered corporation in 1968, and its shares were sold to the public a year later. Initially, Fannie Mae was limited to investing in residential mortgages insured by the FHA or guaranteed by the Veterans Administration so as to maintain its public purpose of assisting entry-level homebuyers.
A few years after Fannie Mae's "privatization," Congress authorized the creation of another government-sponsored mortgage credit facility, Freddie Mac, as a federally chartered corporation to provide a secondary market for the conventional mortgages written by savings and loans and other lenders and brokers. Over time, the mandates guiding the FNMA and FHLMC were liberalized, and the scope of their activity was expanded substantially to the point that they and the other federal housing finance programs now account for more than half the residential mortgage market in the United States.
Although structured as private companies, both the FNMA and the FHLMC operate with valuable federal privileges that give them a significant competitive advantage over other participants in the housing finance market. In particular, they are exempt from state and local income taxes; more important, they have exclusive access to lines of credit from the U.S. Treasury and the U.S. Federal Reserve System. Under current law, each is permitted to borrow up to $2.25 billion from the Treasury, and the Federal Reserve is authorized to purchase their debt as part of any "open market operation." Although neither of these privileges has ever been requested, the fact that the federal government is authorized to assist these GSEs is interpreted by investors as an implied federal guarantee of their debt, and this interpretation allows them to borrow at interest rates well below those paid by private companies with the best credit ratings and only slightly higher than what the Treasury pays on its own full faith and credit debt.
As quasi-private companies obligated to enrich their shareholders with ever-increasing earnings and dividends, and operating with an implicit federal interest rate subsidy as well as a federal mandate to promote homeownership, Fannie Mae and Freddie Mac had every reason and opportunity to grow rapidly. By the 1980s and early 1990s, they dominated the housing finance market. By parlaying their subsidized borrowing advantage into lower-rate mortgage lending, they gradually pushed life insurance companies and commercial banks out of the less profitable residential mortgage market and squeezed the earnings of the already wobbly savings and loans, which by law could invest only in residential mortgages. While homebuyers benefited from slightly lower borrowing costs, financial markets were put at greater risk as more and more of the housing finance system was concentrated in the hands of two highly leveraged, unsupervised, federally chartered financial institutions.