Fannie Mae, Freddie Mac and the Meaning of Conforming Loans
Money is finite. If funding new loans relied exclusively on the money generated from the mortgages already in a lender’s portfolio the lending market would stall. Much of the lender’s monetary assets would be already locked up waiting for 15 and 30 year mortgages to mature. They would be unable to offer new loans, because there would be no available money to lend.
To foster a healthy lending market, Fannie Mae and Freddie Mac were created. Both of these institutions are government-sponsored enterprises (also known as GSE’s). These mortgage focused GSE’s are publicly traded companies that were initially founded by the federal government to increase the number of lenders able to invest in the housing market. They accomplish this through the secondary mortgage market (which they themselves established). Both Fannie Mae and Freddie Mac purchase whole loans from lenders and repackage them in the form of mortgage-backed securities to sell to investors or retain directly. This more immediate return frees up lenders’ funds allowing them to offer a greater abundance of loans.
Conforming loans “conform” to the terms and conditions set by Fannie Mae and Freddie Mac. Since both entities are corporations and neither are part of the government these are considered conventional loans. Both GSE’s will only buy loans that are conforming to its maximum loan size. This conforming loan limit is based on the national annual mean home price and is dictated by the Federal Housing Finance Agency. For 2014 the single-family max is $417,000 outside of designated “high cost areas” such as Hawaii and Alaska ($625,500 for single family in high cost areas).
Since GSE’s will not buy loans that are non-conforming (over their max sizes), they have lesser demand in the secondary market. This makes the non-conforming loans a bigger risk for the lender and thus higher rates.