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Tess Vigeland: Now that tax season is over, there’s nothing left to do but wait for that rebate check we just mentioned, but that’s not the only gift Uncle Sam is handing out this year.
The economic stimulus package also allows Freddie Mac and Fannie Mae to buy mortgages worth up to $729,750. For those of us in really expensive parts of the country, it’s supposed to means cheaper home loans, but how does this all work? And what exactly is the role of Fannie and Freddie, anyway?
For answers, we turn to Susan Wachter at the Wharton School of Business and let’s start with the basics: are Fannie Mae and Freddie Mac different entities?
Susan Wachter: Historically they were, now they are not. They are different corporations, they’re owned by different shareholders, there are nuances of differences, but effectively, they have the same mission and they operate the same way.
Vigeland: Now you talk about how they are corporations owned by shareholders, but we also almost always proceed Fannie Mae and Freddie Mac with this phrase “government-sponsored entities.” What does that mean?
Wachter: They are implicitly guaranteed by the federal government. They have explicit statements that they are not guaranteed by the federal government, but there are many reasons and markets assume that the federal government is standing behind them. Even in times of great turmoil, such as we see now, Fannie and Freddie mortgages, guaranteed mortgages, are quite stable.
Vigeland: Give us, in its most basic terms, an idea of what these companies actually do. They don’t originate mortgages. They don’t hand them out like a bank.
Wachter: They absolutely do not originate mortgages; that is not in their charter. They are the entities that guarantee the funds that are coming from other investors ultimately back to the banks who are providing the funds for mortgages. So, a borrower goes in, seeks a mortgage, that mortgage is originated by the bank, but the bank ultimately does not fund a Fannie/Freddie-guaranteed mortgage. What the bank does… that mortgage plus a lost of others are pooled together in what’s called a Fannie or Freddie security. Those securities are ultimately funded by secondary market investors — they’re pension funds, they’re insurance companies. Now, why are they providing these funds? In part, because Fannie and Freddie are guaranteeing their funds will be repaid.
Vigeland: Are there any subprime loans that were backed by Fannie and Freddie or would that have been impossible?
Wachter: That would have been impossible. Fannie and Freddie’s mission makes it impossible. They can only guarantee investment-grade, which does not include subprime mortgages.
Vigeland: Let’s talk about Fannie and Freddie and the role that they play in this notion of conforming loans versus jumbo loans. Now there is a number that is set, I believe by Congress, above which you are a jumbo loan and below which you are what is called a conforming loan. How is this number set, first of all?
Wachter: The number is set by Congress. Fannie and Freddie must abide. It has been, until recently, as you say, $417,000. It does change slightly every year, but it basically has been within these numbers, a few percentage points lower every year. It has gone up, though, dramatically recently through congressional legislation.
Vigeland: And what is the difference then between a conforming loan and a jumbo loan? What do those mean for people?
Wachter: Conforming loan means that they can be guaranteed by Fannie and Freddie. They conform to Fannie and Freddie’s standards, so if your mortgage is qualified to be in a Fannie and Freddie mortgage-backed security, it means that you are going to be paying substantially less for your mortgage.
Vigeland: In terms of a interest rate?
Wachter: In terms of your mortgage payment, in terms of your interest rate, it will be substantially less.
Vigeland: And the reason behind Congress boosting this number under which you are a conforming loan, that’s because so many states have median home prices that are and were way beyond the $417,000, right?
Wachter: Absolutely, so in this recent — although now reversing — housing boom which has caused housing prices in states like Florida, in California, to exceed the median price, to exceed the standard for conforming loans for Fannie and Freddie.
Vigeland: Both Fannie and Freddie got in trouble a couple of years ago for accounting scandals and at that point, there was some talk in Congress about restricting them much more than had been the case. At this point, is all that kind of out the window?
Wachter: In some ways, it is. In fact, those restrictions, which were put in place, have been removed and some of the talk is that they’ve been removed because the accounting is better in place, but it’s not just that. The reality is that right now, we are depending on Fannie and Freddie to help get us out of this subprime mess.
Vigeland: Susan Wachter is professor of real estate and finance at the Wharton School at the University of Pennsylvania. Thank you so much for helping us out today.
Wachter: Thank you Tess. It’s a pleasure.
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