US & World Economies US Economy Fiscal Policy Did Fannie and Freddie Cause the Mortgage Crisis? The reality is a bit more complex By Kimberly Amadeo Kimberly Amadeo Kimberly Amadeo is an expert on U.S. and world economies and investing, with over 20 years of experience in economic analysis and business strategy. She is the President of the economic website World Money Watch. As a writer for The Balance, Kimberly provides insight on the state of the present-day economy, as well as past events that have had a lasting impact. learn about our editorial policies Updated on May 2, 2022 Reviewed by Robert C. Kelly Reviewed by Robert C. Kelly Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital. learn about our financial review board Fact checked by Hans Jasperson Fact checked by Hans Jasperson Hans Jasperson has over a decade of experience in public policy research, with an emphasis on workforce development, education, and economic justice. His research has been shared with members of the U.S. Congress, federal agencies, and policymakers in several states. learn about our editorial policies Photo: Sean Martin/Getty Images Were Fannie Mae and Freddie Mac the real cause of the subprime mortgage crisis? It's dangerous to think so. In reality, they were a prime example of the broader economic forces that caused the banking credit crisis and bailout. Legislative attempts to rapidly wind down Fannie and Freddie would not prevent another recession. Worse yet, it could devastate the housing market. Role in the Mortgage Market Fannie and Freddie were government-sponsored enterprises (GSEs). Like private companies, they had to be competitive to maintain their stock prices. At the same time, the federal government implicitly guaranteed the value of the mortgages they resold on the secondary market. That caused them to hold less capital to support their mortgages in case of loss. As a result, Fannie and Freddie were pressured to take on risk to be profitable. With government backing, they also knew they wouldn't suffer the consequences if things turned south. The government set them up this way to allow them to buy qualified mortgages from banks, insure them, and resell them to investors. Banks used the funds to make new mortgages. Historically, Fannie and Freddie supported half of all new mortgages issued each year (as they do again today). By December 2007, when banks began to constrict their lending, Fannie and Freddie accounted for 90% of all mortgages originated. Role During the Housing Crisis Government regulations prohibited Fannie and Freddie from buying high-risk mortgages. But as the mortgage market changed, so did their business. Between 2005 and 2007, they acquired a few conventional, fixed-interest loans with 20% down. They loaded up on subprime, interest-only, or negative amortization mortgages—loans more typical of banks and unregulated mortgage brokers. Fannie and Freddie made things worse by their use of derivatives to hedge the interest-rate risk of their portfolios. But as private-sector companies with shareholders to please, they were doing this to remain competitive with other banks. They were all doing the same thing. Fannie Mae's loan acquisitions were: 62% negative amortization84% interest-only58% subprime62% required less than 10% downpayment Freddie Mac's loans were even riskier, consisting of: 72% negative amortization97% interest-only67% subprime68% required less than 10% downpayment These exotic and subprime mortgages made Fannie and Freddie's loan acquisitions toxic. Less Toxic than Most Banks Regulations made sure Fannie and Freddie took on fewer of these loans than most banks. Still, they acquired more of these loans to maintain market share amid tightening competition. In 2005, the Senate sponsored a bill that prohibited them from holding mortgage-backed securities in their portfolios. Congress wanted to reduce the risk to the government. By 2009, the two GSEs owned or guaranteed 44%, or $4.8 trillion (in 2009 dollars), of residential mortgage debt, up from 36% in 2006. But the Senate bill failed, and Fannie and Freddie increased their holdings of risky loans. They could make more money from the loans' high interest rates than from the fees they got from selling the loans. Again, they were seeking to maintain high stock prices in a very competitive housing market. As government-sponsored enterprises, Fannie and Freddie took on more risk than they should have. They didn't protect the taxpayers who ultimately had to absorb their losses. But they didn't cause the housing downturn. They didn't flood the market with exotic loans. They were a symptom, not a cause, of the mortgage crisis. Derivatives Helped Cause Their Downfall According to some estimates, only 17% of their portfolios in 2007 were subprime or Alt-A loans. But then housing prices declined, and homeowners began defaulting. As a result, this relatively small percentage of subprime loans contributed substantially to the losses. As GSEs, Fannie and Freddie weren't required to offset the size of their loan portfolios with enough capital from stock sales to cover it. It was a result of both their lobbying efforts and the fact that their loans were insured. Instead, they used derivatives to hedge the interest-rate risk of their portfolios. When the value of the derivatives fell, so did their ability to guarantee loans. This exposure to derivatives proved their downfall, as it did for most banks. As housing prices fell, even qualified borrowers ended up owing more than the home was worth. If they needed to sell the house for any reason, they would lose less money by allowing the bank to foreclose. Borrowers in negative amortization and interest-only loans were in even worse shape. Eliminate Fannie and Freddie? Some legislators propose eliminating Fannie and Freddie. Others suggest that the United States copy Europe in using covered bonds to finance most home mortgages. With covered bonds, banks retain the credit risk on their home mortgages. They sell bonds backed by those mortgages to outside investors. That allows them to offload interest-rate risk. If Congress eliminated Fannie and Freddie, it would dramatically reduce the availability of mortgages and increase the cost. Banks hesitate to issue mortgages that aren't guaranteed. Mortgage interest rates could rise. The U.S. housing market would collapse. Note A homeowner who put 20% down on a $300,000 home with a 4.5% interest rate today would pay $1,216 a month in principal and interest. The same loan at 9% would result in a monthly P&I payment of $1,931. Instead of eliminating Fannie and Freddie, the current route of tighter regulation and risk management seems the better option. These GSEs didn't cause the financial crisis, and eliminating them won't prevent another one. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Urban Institute. "Housing Finance at a Glance: A Monthly Chartbook (April 2020),"Page 8. Ronald Spahr and Mark A. Sunderman. "The U.S. Housing Finance Debacle, Measures to Assure its Non-Recurrence and Reform of the Housing GSEs," Pages 74-75. Journal of Real Estate Research. Congressional Budget Office. "Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market," Pages 10-11. Congressional Research Service. "GSEs and the Government’s Role in Housing Finance: Issues for the 113th Congress," Pages 7-8. Congressional Research Service. "Fannie Mae and Freddie Mac in Conservatorship: Frequently Asked Questions," Page 2.