The current credit crisis has taken the United States by storm with people from nearly all walks of life being affected by it. It has to be said however that this sub-prime crisis as it is known was a long time coming with its roots being laid much earlier than 2008. Since Greenspan lowered the interest rates to 1% which saw increased lending, investment banks found themselves with a lot of money and enough to spare as well (Krugman). This, therefore, led to the increased demand for mortgages leading to the need to allow more people to take out mortgages. This is where the crisis started.
In the midst of the credit crunch, mortgage lenders had a big role to play. Two such institutions were the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both of these are privately owned but government sponsored enterprises which issue out mortgages. Their unique status means that the private investors can enjoy the profits made by these enterprises if any and they can bank on the US government coming to their rescue if they start making losses which provides these two with a unique level of assurance, allowing them the ability to take a greater risk.
This is where their role in the current credit crisis comes in. As increased lending by investment banks on account of low-interestrest rates spurred the demand for buying out mortgages by investors and other financial institutions, there a was greater need for mortgages to be issued out as they were considered safe investments. The homeowners who could afford to pay back their mortgages were a good source of funds allowing a greater rate of return to investors compared to the 1% they got on treasury bills. In the case of those homeowners who could not make their payments, the mortgage-owning institutions could easily take over the house and sell it. Since real estate prices were continuously on the rise, this appeared a considerably safe investment with a good rate of return. Hence the need for issuing out more mortgages to households arose as they were considered less risky.
Mortgage lending institutions such as Fannie Mae and Freddie Mac and other private ones evaluate the ability of households to pay back their mortgage before they issue them loans. This involves checking their employment and financial standing. Loans were issued out to only those who were rated as “prime” or able to make their payments. Since the ability to acquire the house as collateral on default of payments allowed these institutions to guarantee good payment, most of the mortgage lenders started issuing very attractive “sub prime” loans to those who could not normally qualify for a mortgage. These contained normally no down payment clauses with comparatively very low interest rates, allowing a large part of the public to purchase houses which further drove up prices, making mortgage issuance safer. This is because if the households defaulted, the house could be acquired and sold at the higher price.
Fannie Mae and Freddie Mac were said to be involved in a lot of these sub prime loans being issued. As the loans got issued to these below par applicants, the repercussions started arising a few years later. Many of these mortgage holders started defaulting on their payments leaving the mortgage lenders with their houses which in turn were put up for sale. As more of this trend continued, the supply of homes started outstripping demand, leading to a fall in house prices. This therefore led to the prime rated mortgage taking households to stop payments as well and hand over their low price houses. The spill over effect went to investors who had bought these sub prime loans and to investment banks and other financial institutions. Since now households were unwilling to buy mortgages and investors were unwilling to purchase the defaulting ones, it led to the credit crisis in America. One can thus say that the issuance of sub prime loans started the current financial crisis which was the business of Fannie Mae and Freddie Mac which were in a better position to take this risk considering they can be bailed out from possible losses by the US government.
However, there has emerged some criticism about this blame. Many analysts are now arguing that the two mortgage giants are too heavily regulated for that to happen. This puts restrictions on them to willingly hand out sub prime loans (Krugman). There are also now figures suggesting that private mortgage issuing institutions were more involved in this sub prime lending during the years it was really taking off. This brings us to the view that Fannie Mae and Freddie Mac may have suffered then actually caused the credit crunch since the bursting of the housing bubble was so huge that it led to a dramatic fall in house prices leading to even the prime rated households that the two issued loans to defaulting.
References
Krugman , Paul. “Fannie, Freddie and You.” The New York Times. 2008. The New York Times. 2009. Web.