Freddie Mac definition: Explained
BY TIO Staff
|July 12, 2024Freddie Mac, formally known as the Federal Home Loan Mortgage Corporation (FHLMC), is a government-sponsored entity (GSE) that plays a crucial role in the United States' secondary mortgage market. Established by Congress in 1970, Freddie Mac's primary mission is to provide liquidity, stability, and affordability to the U.S. housing market.
By purchasing mortgages from lenders, packaging them into mortgage-backed securities (MBS), and selling them to investors, Freddie Mac helps ensure a continuous supply of mortgage funding. This process is vital to the functioning of the housing market and the broader economy. This article will delve into the intricacies of Freddie Mac, its role in the trading market, and its impact on the economy.
Origins and Purpose of Freddie Mac
Freddie Mac was created to expand the secondary market for mortgages in the U.S. Prior to its establishment, the secondary mortgage market was primarily served by the Federal National Mortgage Association (Fannie Mae), which was created during the Great Depression to stimulate the housing market. However, in the late 1960s, the government decided to create a second institution to ensure competition and reduce the risk of a single point of failure.
Freddie Mac was thus established in 1970 to buy mortgages, pool them, and sell them as mortgage-backed securities to investors on the open market. This process provides lenders with the liquidity necessary to make more loans, which in turn helps more people afford homes. Freddie Mac also helps stabilize mortgage markets and protect housing during extreme economic conditions, such as a depression.
Freddie Mac's Impact on the Housing Market
By purchasing mortgages from lenders, Freddie Mac provides them with the capital necessary to lend to more borrowers. This increases the availability of mortgage loans, making homeownership more accessible for Americans. Furthermore, by pooling mortgages and selling them as securities, Freddie Mac helps distribute and diversify risk, contributing to the stability of the housing market.
Freddie Mac's activities also influence mortgage rates. When Freddie Mac purchases mortgages and sells them as securities, it increases the demand for these loans, which can lead to lower interest rates. Conversely, if Freddie Mac reduces its purchases, it can lead to higher interest rates. Thus, Freddie Mac plays a significant role in determining the cost of homeownership for many Americans.
Freddie Mac and the Trading Market
Freddie Mac's mortgage-backed securities are a major component of the U.S. bond market, one of the largest and most liquid financial markets in the world. These securities are traded by a wide range of investors, including mutual funds, pension funds, insurance companies, and foreign governments. They offer a way for investors to gain exposure to the U.S. housing market without having to buy physical properties.
Trading in Freddie Mac securities can be influenced by a variety of factors, including changes in interest rates, the health of the U.S. housing market, and the creditworthiness of the underlying mortgages. Traders also closely watch the actions of the U.S. government, as it has a significant influence on Freddie Mac through its regulatory oversight and its role as a conservator since the 2008 financial crisis.
Types of Freddie Mac Securities
Freddie Mac issues several types of mortgage-backed securities. The most common are pass-through securities, in which investors receive a pro-rata share of the principal and interest payments from a pool of mortgages. Freddie Mac also issues structured securities, which have cash flows that are divided into different classes, or tranches, based on their risk and return characteristics.
Freddie Mac's securities are considered to be relatively safe investments due to the implicit backing of the U.S. government. However, they are not without risk. Investors face the risk of prepayment, which occurs when homeowners refinance their mortgages or sell their homes, causing the underlying mortgages to be paid off early. This can reduce the yield on the securities. Investors also face the risk of default if the homeowners fail to make their mortgage payments.
Freddie Mac's Role in the 2008 Financial Crisis
Freddie Mac played a central role in the 2008 financial crisis, which was triggered in large part by a collapse in the U.S. housing market. Leading up to the crisis, Freddie Mac and its sister institution, Fannie Mae, had taken on significant risk by investing heavily in subprime and other high-risk mortgages. When home prices fell and mortgage defaults surged, the two institutions suffered massive losses.
In September 2008, the U.S. government placed Freddie Mac and Fannie Mae into conservatorship, a form of bankruptcy protection. The government took control of the institutions and injected billions of dollars to keep them afloat. Since then, Freddie Mac has been operating under the conservatorship of the Federal Housing Finance Agency (FHFA), with its profits going to the U.S. Treasury.
Reforms and Current Status
Since the financial crisis, Freddie Mac has undergone significant reforms to reduce its risk and improve its operations. It has tightened its underwriting standards, increased its capital reserves, and reduced its portfolio of high-risk mortgages. It has also introduced new risk-sharing initiatives to transfer a portion of its credit risk to private investors.
Despite these reforms, Freddie Mac remains a critical part of the U.S. housing finance system. It continues to provide liquidity to the mortgage market, helping to keep mortgage rates low and homeownership affordable for millions of Americans. The future of Freddie Mac is a topic of ongoing debate, with proposals ranging from privatization to a restructuring of the entire U.S. housing finance system.
Conclusion
Freddie Mac plays a vital role in the U.S. housing market and the broader economy. By purchasing mortgages from lenders and selling them as securities, it provides liquidity to the mortgage market, helps stabilize housing markets, and makes homeownership more affordable. Its securities are a major component of the U.S. bond market, offering investors a way to gain exposure to the housing market.
However, Freddie Mac's activities also entail risks, as evidenced by its central role in the 2008 financial crisis. Its future is uncertain, with ongoing debates about its structure and role in the housing finance system. Regardless of its future direction, Freddie Mac's impact on the housing market and the broader economy is likely to remain significant for years to come.
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