This blog post accompanies the SDPB Monday Macro segment that airs on Monday, December 4, 2023. Click here to listen to the segment. For more macroeconomic analysis, follow J. M. Santos on Twitter @NSMEdirector.

As the average national interest rate on the thirty-year, fixed-rate mortgage has risen above 7 percent, seems everyone is probing the question of how to make housing—and, specifically, homeownership—more affordable. For everyone, the cost of owning a home is driven in part by the ability to finance the purchase of a home. We discuss mortgage rates often. We discuss whether rates will stay higher for longer, or whether rates will fall sooner rather than later. We think about mortgage rates in terms of the demand and supply for loanable funds: if the demand for loanable funds rises relative to the supply of loanable funds, mortgage rates rise, and so on. We talk far less about the nature of the U.S. mortgage market and, specifically, the thirty-year, fixed-rate mortgage, upon which so many of us depend to purchase a home. Turns out, in the U.S. mortgage market—and, so, the U.S. housing market—private demanders and suppliers of mortgage financing are not alone. Were we to be, the terms of mortgage financing and the features of the U.S. housing market would look quite different than they do today.

In her book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants (2015), Bethany McLean recalls former Bank of England Governor, Mervyn King, telling her:

Most countries have socialized health care and a free market for mortgages. You in the United States do exactly the opposite.

Shaky Ground (NY: Columbia Global Reports, p. 9.)

Governor King was referring to the government-sponsored enterprises (GSEs)—and, according to McLean, U.S. mortgage giants—known as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). In Shaky Ground, McLean chronicles the history and future of Fannie Mae and Freddie Mac, which, as McLean rightly points out, dominate the U.S. mortgage market. McLean focuses on the housing bust around the Global Financial Crisis and the government conservatorship into which the Federal Housing Finance Agency—and, thus, the U.S. Treasury—placed the GSEs in 2008. In any case, Governor King is correct: the U.S. housing market is not free; it has not been so for quite some time.

Housing matters, a lot.

In 1938, the U.S. government created Fannie Mae, a New Deal-inspired facility the government designed to support the housing market in the wake of the Great Depression. Like today, housing mattered then, as did employing people—in this case, employing people to build houses. Supporting the housing industry was a policy priority, and it remains so to this day. Fannie Mae began as a federal agency that bought mortgages insured by the Federal Housing Administration (FHA) or the Veterans Administration (VA). In 1968, the GSE converted into a shareholder-owned corporation. Shortly thereafter, in 1970, the U.S. government created Freddie Mac, a private company from the start that the government authorized to buy conventional loans—those not insured by the HA, VA, or the Farmers Home Administration—and designed to compete with Fannie Mae.

Fannie Mae and Freddie Mac support the housing market in that each buys mortgages from lenders—think, traditional commercial banks that lend to you and me—and either the GSE holds the mortgages in their portfolios or packages them into mortgage-backed securities (MBS) the GSEs could sell to investors. Moreover, Fannie Mae and Freddie Mac insure mortgages: the GSEs provide the lender (who sells the GSEs the loans) a so-called credit enhancement—a mechanism that reduces the risk of default or loss for the lenders and, most importantly, the investors who buy the MBS the GSEs issue. A common example of a credit enhancement is a guarantee fee, which Fannie Mae and Freddie Mac charge the lender—think, the mortgage originator—in return for guaranteeing the timely payment of principal and interest on the underlying mortgage. By insuring mortgages, Fannie Mae and Freddie Mac add liquidity and stability to the mortgage market, lowering interest rates borrowers pay, all else equal. The GSEs absorb the risk of losses if borrowers default on their loans or if the value of the MBS portfolios decline.

Safety nets can be very dangerous.

Fannie Mae and Freddie Mac are intermediaries: to raise the funds necessary to buy mortgages from lenders, Fannie Mae and Freddie Mac issue debt in the financial debt markets; this is to say, to finance their purchases of mortgages, Fannie Mae and Freddie Mac each issues debt securities—think, Fannie and Freddie bonds—of varying maturities. The debt securities are traded in global financial markets. Importantly, both GSEs enjoy government guarantees, so the bonds the GSEs issue are essentially full faith and credit of the U.S. government. This was true even before the Federal Housing Finance Agency placed the GSEs in conservatorship, explicitly backstopping GSE debt with the creditworthiness of the U.S. Treasury—the last line of defense—should the GSEs be unable to pay their debt. In other words, even before conservatorship, everyone understood the guarantee to be implicit. No matter how vociferously the government denied it guaranteed GSE debt, everyone reasoned otherwise: the GSEs were too big—and too important—to fail.

Thus, since their inceptions, Fannie Mae and Freddie Mac have essentially been allowed by financial markets to borrow—and use the proceeds to purchase mortgages from lenders—at low rates of interest, comparable to the rates of interest financial markets charge the U.S. Treasury, for example. The privileged position has allowed Fannie Mae and Freddie Mac to expand their balance sheets, because the low cost of borrowing incentivizes borrowing, which generates proceeds the GSEs use to buy assets—mortgages and MBS, for example. When investors in GSEs charge low rates of interest independently of the risk the GSEs load onto their balance sheets, risk, which is positively correlated with return, rises; the market incentive is simple: if it is cheap, then load up on it. Thus, the government guarantee on the debt Fannie Mae and Freddie Mac issue has tended to grow the GSEs and render them riskier than they would be otherwise—in, say, a private mortgage market. Finally, some observers have argued that prior to the financial crisis in 2008, Fannie Mae and Freddie Mac also faced less regulation and oversight than other financial institutions, exposing the GSEs to even greater risks, especially during the subprime mortgage crisis of 2007-2008. As the housing market collapsed and the value of their MBS holdings plummeted, the GSEs became insolvent and illiquid; thus the transition into conservatorship in September 2008.

Fannie Mae and Freddie Mac occupy a large share of the U.S. mortgage market. The share of new mortgage originations that Fannie Mae and Freddie Mac acquire varies over time, though the shares tend to be quite large in any case. According to the Federal Housing Finance Agency, the combined share of new mortgage originations acquired by the GSEs reached a low of 39 percent in 2005 and a high of 64 percent in 2011, after the subprime mortgage crisis of 2007-2008, when the private sector retreated from the mortgage market, the U.S. government backstopped—or, more pejoratively, bailed out—Fannie Mae and Freddie Mac, and, ultimately, the U.S. government assigned the Federal Housing Finance Agency as the GSEs’ conservator. Since then, the share of new mortgage originations has declined but only slightly—in 2020 the share registered 62 percent, as the private sector recovered and increased its participation in the mortgage market. Meanwhile, according to the National Association of Realtors, Fannie Mae and Freddie Mac support—own, package, resell, or insure, for example—about 70 percent of the U.S. mortgage market; here I refer to the stock of accumulated mortgages as opposed to the flow of new mortgage originations.

U.S. mortgages look like what Fannie Mae and Freddie Mac buy.

The combined share of mortgage originations acquired by Fannie Mae and Freddie Mac is shaped by the types and sizes of mortgages the GSEs are permitted to acquire; these acquisitions, in turn, shape the types and sizes of mortgages outstanding: this is to say, over time, the U.S. mortgage market has increasingly resembled Fannie Mae’s and Freddie Mac’s mortgage portfolios. The GSEs are restricted by statute from acquiring mortgages larger than a preset size defined as the conforming limit, which changes annually based on the average home price. For example, in 2023, the baseline conforming limit for a one-unit property was $726,200, which applies to most of the U.S., except some high-cost areas where the local median home value exceeds the baseline limit; in such areas, the limit could be up to 50 percent of the baseline limit, or up to $1,089,300.

Most important from the perspective of aspiring homeowners is that Fannie Mae and Freddie Mac make possible the 30-year, fixed-rate mortgage; if Fannie Mae and Freddie Mac did not buy, bundle, resell, or insure the (now) conventional mortgage, it likely would not exist to the extent it does today in an otherwise free market for mortgages. Because the 30-year, fixed-rate mortgage allows borrowers to amortize principal and interest over three decades, the mortgage provides homebuyers a steady and affordable source of funding. Of course, for the very reasons the conventional mortgage suits the preferences of borrowers, the conventional mortgage poses a risk to lenders, who must agree to a fixed interest rate for three decades. Thanks to the GSEs, to mitigate the risk to a lender, a lender could originate and then sell their 30-year mortgage to Fannie Mae or Freddie Mac, who then could either hold the mortgage in their portfolios or package the mortgage into an MBS, which Fannie Mae or Freddie Mac would sell to investors. This way, lenders issue a much-preferred debt instrument to aspiring homebuyers, free up sources of funding to lend another day, and reduce exposure to interest-rate fluctuations and credit losses.

The U.S. has a relatively developed mortgage market because the 30-year fixed-rate mortgage is preferred by borrowers and available from lenders—thanks, in large part, to Fannie Mae and Freddie Mac. By buying and securitizing 30-year, fixed-rate mortgages, Fannie Mae and Freddie Mac create a liquid and efficient secondary mortgage market that benefits both lenders and borrowers. To be sure, the 30-year, fixed-rate mortgage is not common or even available in many other countries, where variable-rate mortgages or short-term, fixed-rate mortgages are the norm. For example, in Canada and Germany, mortgage terms to maturity of 5 and 10 years are the norm; and in many countries, variable-rate mortgages—essentially, short-term mortgages because the rate variability implies the loan’s sensitivity to changes in interest rates is high—are the norm. Thus, outside the U.S., shorter-term, fixed-rate mortgages and variable-rate mortgages are more prevalent, thus outside the U.S., borrowers must renegotiate their mortgage terms every few years, which increases the uncertainty and possibly the cost of borrowing to purchase a home.

Borrowed time and limited space.

In theory, lowering the uncertainty and cost of borrowing increases the demand for borrowed funds and thus, the demand for homes. Aspiring homebuyers are more likely to enter the market to buy a home if the mortgage terms are relatively favorable. Most aspiring homebuyers would view a 30-year, fixed-rate mortgage favorably. In this way, the prevalence of the government-subsidized, 30-year, fixed-rate mortgage in the U.S. likely shapes patterns of homeownership in the U.S. Put differently, transportation flows and zoning laws—each motivated by long, complicated U.S. histories—explain much about how we live now. But could the relatively favorable terms on a conventional mortgage, one quite unconventional by international standards, explain how we live now—in homes if we could; in apartments if we must—as well? And if so, how might reforming the structure of Fannie Mae and Freddie Mac, which remain in (temporary?) government conservatorship, shape patterns of homeownership going forward? Private demanders and suppliers of mortgage financing will likely never be alone in the U.S. mortgage market. Nevertheless, rationalizing the purpose and function of Fannie Mae and Freddie Mac—or at least publicly debating how and whether to do so—should be something we think about when we think about housing and its affordability in the U.S.