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The Imminent Fannie Mae and Freddie Mac Debacle

Fannie Mae “is a government sponsored enterprise (GSE) of the United States federal government. It is a shareholder-owned corporation authorized to make loans and loan guarantees. It is not backed or funded by the U.S. government, nor do the securities it issues benefit from any statutory government guarantee or protection. It is the leading market-maker in the U.S. secondary mortgage market, which helps to replenish the supply money for mortgages and enables money to be available for housing purchases. The name “Fannie Mae” is a creative pronunciation of the company’s initialism that has been adopted officially for ease of identification.”

Freddie Mac “is a government-sponsored enterprise (GSE) of the United States federal government. It is a stockholder-owned corporation authorized to make loans and loan guarantees. The FHLMC was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. ... From 1938 to 1968, the secondary mortgage market in the United States was monopolized by the Federal National Mortgage Association (Fannie Mae), which was a government agency during that period. In 1968, to help balance the federal budget, part of Fannie Mae was converted to a private corporation. To provide competition in the secondary mortgage market, and to end Fannie Mae’s monopoly, Congress chartered Freddie Mac as a private corporation.”

Back in November 2004, I noted that:

Fannie Mae is a disaster waiting to happen. The trouble is that it is neither fish nor fowl. Fannie Mae’s government connections insulate it from discipline by markets and investors. Worse yet, the markets believe (with some justification) that the federal government has (implicitly) guaranteed fannie Mae’s debts, which allows it to also avoid by market discipline by borrowing at below-market rates. Moreover, because the board includes political appointees, it is further insulated from investor discipline. The solution is privatization. Let it run as a for-profit corporation in a competitive market, with full disclosure.

In February 2005, I identified a number of major problems at Fannie Mae and Freddie Mac:

1. It is simply not true that Freddie and Fannie’s hedging techniques are "fairly transparent and conservative," as some of their defenders absurdly claimed. To the contrary, as Berkeley business school professor Dwight Jaffee has demonstrated their hedging practices create "imperfect hedges and thus could impose significant costs on U.S. taxpayers in a potential future F&F bailout."
2. Investors believe that because of the quasi-governmental status of Freddie Mac and Fannie Mae, the government will never let them fail. As Clinton Administration Assistant Treasury Secretary Richard Carnell observes: "[They] tell Congress and the news media, “Don’t worry, the government is not on the hook”—and then turn around and tell Wall Street, “Don’t worry, the government really is on the hook.” This enables Freddie and Fannie to achieve a lower cost of capital than competitors by selling equity at higher prices or to borrow at an interest rate below that available to potential competitors. At the same time, the implicit government guarantee apparently encourages management to take risks that firms subject to market competition and lacking a government safety net would never take. In particular, as the Economist pointed out, Freddie and Fannie increasingly hold on to mortgages rather than reselling them as asset backed securities, which exposes them to much higher repayment and other risks.
3. Freddie and Fannie have serious and well-documented corporate governance problems. Harvard law professor Lucian Bebchuk and Boalt law professor Jesse Fried, for example, have identified four problems with Fannie Mae’s executive compensation arrangements:  "First, by richly rewarding executives for reporting higher earnings, without requiring return of the compensation if earnings turned out to be misstated, Fannie Mae’s arrangements provided perverse incentives to inflate earnings. Second, Fannie Mae’s arrangements provided soft landings to executives who were pushed out by the board for failure; expectation of such outcome adversely affected ex ante incentives. Third, even if the executives had retired after years of unblemished service, the value of their retirement packages would have been largely unrelated to their own performance while in office, weakening the link between pay and performance. Fourth, both when promising retirement payments to executives and when making these payments, Fannie Mae’s disclosures obscured rather than made transparent the total values of the executives’ retirement packages."
4. In an excellent overview of the issues, Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?, Fed economist W. Scott Frame and NYU economics professor Lawrence J. White argue, inter alia, that Freddie and Fannie in fact do not focus on "lower middle class mortgage[s]." Instead, they argue, much of Freddie and Fannie’s lending activities benefit home buyers in higher economic groups.

Finally, in September 2005, I wrote that:

If there really is a housing bubble, both Freddie Mac and Fannie Mae presumably would take a major hit. Is there any alternative to a government bailout if they start down the tubes? I recently found an interesting article by law professor Richard Carnell has lots of good information on the risks we taxpayers are bearing because of Fannie Mae and Freddie Mac’s borrowing habit and lousy corporate governance. He also proposes creating a mechanism for dealing with any potential insolvency on their part.

This is an issue that’s been flying under everybody’s radar screen, but is a key issue given the state of the housing market. Carnell’s article is a good introduction to this important problem.

Now the chickens are coming home to roost and even the NY Times has finally noticed:

Jim Leach, a Republican former representative from Iowa, ... argued two decades ago in Congress that the government-chartered mortgage companies, Fannie Mae and Freddie Mac, were unfairly insulated from the real world.

They were not subject to the same financial standards and tax burdens as their competitors, he warned, and if they ran into trouble, an implicit government guarantee to back them up meant taxpayers would be left with the losses.

“There are times in public policy making that one can feel like Don Quixote,” Mr. Leach said of his repeated legislative battles to rein in the two companies’ growth.

Fannie and Freddie should have been fully privatized years ago, so that they were subject to market competition; alternatively, although less ideally, they should have been brought back into the government to be regulated more effectively. Leach was right that leaving them as they were was a disaster waiting to happen. And now it looms larger than ever, with potential disastrous implications, as Tom Petruno explains:

On Friday, rumors swamped financial markets that the federal government would be forced to step in to aid mortgage-finance giants Fannie Mae and Freddie Mac, which together own or guarantee $5 trillion in U.S. home loans.

In Wall Street’s version of a bank run, investors drove shares of Fannie Mae and Freddie Mac to 17-year lows, signaling a gnawing lack of faith in the companies’ ability to survive rising mortgage defaults without government help.

As predicted on this site all those years ago, when push comes to shove, the government will not have the cojones to let Fannie and Freddie fail:

Despite the companies’ assurances that they have adequate capital cushions against surging defaults on the mortgages they own or guarantee, the market doesn’t believe them.

For the federal government, that poses a quandary. Because of their size and importance to the mortgage market, it’s inconceivable that Fannie and Freddie would be allowed to fail.

A government takeover, however, would be a financial disaster that might unthinkable consequences:

But an outright takeover of the companies by the government, as some experts have suggested, could frighten foreign investors—who are big lenders to the Treasury—by, in effect, adding the companies’ $5-trillion debt load to the Treasury’s massive debt of $9.5 trillion.

Nationalizing the companies “would put the full faith and credit of the Treasury at risk,” Sinai said. “It would make foreign investors think hard about buying U.S. Treasury debt.”

Want a worst case scenario? The government takes over Fannie and Freddie. The immense increase in the national debt causes the bond rating agencies to cut their rating of Treasury securities from their traditional AAA. Along with other economic problems (whether its mostly whining or not), this spooks investors, especially foreign investors. Foreigners abandon the dollar for the euro, dumping treasuries. The collapse of foreign investment in Treasuries makes our massive current account deficit unsustainable. At which point, things really go to pot.

All because our leaders in Washington failed on a bipartisan basis to address the problems at Fannie and Freddie. Why didn;t they do something? Because Fannie and Freddie bribed them and because they’re petrified of being painted as anti-consumer, as even the Times finally noticed:

The companies, Wall Street, mortgage bankers, real estate agents and Washington lawmakers have built up an unusual and mutually beneficial co-dependency, helped along by robust lobbying efforts and campaign contributions.

In Washington, Fannie and Freddie’s sprawling lobbying machine hired family and friends of politicians in their efforts to quickly sideline any regulations that might slow their growth or invite greater oversight of their business practices. Indeed, their rapid expansion was, at least in part, the result of such artful lobbying over the years.

And as Fannie and Freddie grew, so did the fortunes of Wall Street, which reaped rich fees from issuing debt for the two companies, as well as the mortgage and housing industries, which banked billions of dollars as the housing market boomed.

Even after accounting scandals arose at the two companies a few years ago, attempts to push through stronger oversight were stymied because few politicians, particularly Democrats, wanted to be perceived as hindering the American dream of homeownership for the masses.