What role did Fannie Mae and Freddie Mac, often called 'the Two Houses' on Wall Street, play in the 2008 financial crisis?

Alright, no problem. Let's talk about the role Fannie Mae and Freddie Mac played in the 2008 financial crisis.

Imagine this: you want to buy a house, but banks' money doesn't grow on trees. After lending you money, they want to get it back quickly so they can lend it to the next person and make more profit. This is where Fannie Mae and Freddie Mac come in.

What are the "Two Fannies"? – The Financial Market's "Conduits"

Fannie Mae and Freddie Mac, which we'll refer to as the "Two Fannies" for short, don't directly lend money to homebuyers themselves. Instead, they purchase mortgages from banks.

Here's how the process works:

1. You take out a mortgage from a bank to buy a house: The bank lends you 1 million, which you repay over time.
2. The bank sells your "promissory note" to the "Two Fannies": The bank doesn't want to wait 30 years to get back that 1 million. So, it bundles and sells your signed loan contract (this "promissory note") to Fannie Mae or Freddie Mac, getting cash back immediately.
3. The bank continues lending: With new funds, the bank can then lend to the next homebuyer.

The "Two Fannies" played a crucial role as financial conduits. Their existence allowed money to flow quickly through banks, ensuring a continuous supply of funds in the market to support more people buying homes. In normal times, this was beneficial, promoting a thriving real estate market.

How Did the Crisis Emerge? – The "Conduits" Started Transporting "Dangerous Goods"

Before the 2008 financial crisis, the U.S. real estate market was booming, with housing prices constantly rising. To enable more people to buy homes, and also to earn more money, banks began to lower their lending standards repeatedly.

• The Rise of "Subprime Mortgages": Previously, only individuals with good credit and stable incomes could get loans. Later, even people without stable jobs or with very poor credit histories (the so-called "subprime" borrowers) could easily obtain loans. These were Subprime Mortgages.

This was like lending money to someone highly likely to default, carrying extremely high risk.

Initially, the "Two Fannies" were very selective, only acquiring "prime mortgages" – those with good quality and low risk. However, other Wall Street investment banks soon discovered that packaging these "subprime mortgages" into financial products (called MBS, Mortgage-Backed Securities) and selling them to investors was incredibly profitable.

Faced with immense performance pressure and market competition, the "Two Fannies" couldn't stand by. They too began to acquire these "subprime mortgages" – essentially "dangerous goods" – on a large scale.

The "Two Fannies'" Core Role in the Crisis: Amplifier and Guarantor

You can think of the "Two Fannies" as a massive risk amplifier.

1. Provided Banks with "Unlimited Ammunition": Because the "Two Fannies" were willing to purchase these high-risk subprime mortgages, banks became more emboldened to lend money to unreliable borrowers. Banks could simply offload the risk to the "Two Fannies" and make a guaranteed profit. This led to the market being flooded with astronomical amounts of "subprime mortgages."

2. Provided a "False Sense of Security": Although the "Two Fannies" were publicly traded companies, they had an "Implicit Guarantee" from the U.S. government. Everyone believed these two companies were too big to fail, and that if anything went wrong, the government would surely intervene to save them.

   • It was precisely because of this "official backing" that the MBS issued by the "Two Fannies" were rated AAA – the safest investment products.
   • Investors worldwide, including pension funds, insurance companies, and foreign governments, confidently purchased these "safe" products, which were packaged from "subprime mortgages."

The core role of the "Two Fannies" was this: They leveraged their government backing to stamp a "safe and reliable" seal on a pile of "toxic assets" (subprime mortgages), and then sold them to the world.

The Final Outcome: The Avalanche

When the housing bubble burst and home prices began to fall, the problems erupted.

• Those "subprime" borrowers found their homes were worth less than their mortgages, couldn't afford their monthly payments, and simply defaulted.
• Massive defaults instantly turned the loans held by the "Two Fannies" and the MBS they guaranteed into astronomical amounts of bad debt.
• These two behemoth companies, with asset sizes larger than the GDP of many countries at the time, held too many toxic assets and instantly became insolvent, teetering on the brink of bankruptcy.

If they had collapsed, the global financial system would have followed suit, as financial institutions worldwide held the securities they guaranteed. This was the so-called "systemic risk."

Ultimately, the U.S. government had to intervene, taking over the "Two Fannies" in September 2008 and using hundreds of billions of taxpayer dollars to fill the hole, but this could no longer prevent the financial tsunami that swept across the globe.

To summarize the role of the "Two Fannies":

• During the boom: They were the engine and lubricant of the real estate market.
• During the crisis: They were risk amplifiers and credit guarantors. They didn't create the first bomb (subprime mortgages), but they built a massive arsenal, packaged thousands of bombs, labeled them "safe," and sold them to the world, ultimately detonating the entire financial system.