Fannie Mae & Freddie Mac: How we got here and what to do next

Fannie Mae and Freddie Mac are privately owned and run government sponsored enterprises (GSEs). Fannie Mae was founded as a government agency in 1938 to develop the secondary mortgage market. In 1968, in part to remove its activity from the federal budget, it was converted into a private corporation. In 1970, Freddie Mac was created by Congress, also as a private corporation, to expand the secondary mortgage market.

The GSEs purchase mortgage loans from banks. Those banks are happy to sell their mortgages to free up capital to originate more mortgages and to avoid interest rate risk – they mostly issue long term fixed rate mortgages but pay their depositors a variable rate of interest leaving them vulnerable to increases in interest rates. The GSEs then combine similar loans into mortgage pools. These pools are formed into pass-through securities where the principal and interest on the mortgages in the pool are passed through to the investors in the securities. The GSEs can either sell the mortgage-backed securities to other investors or retain the securities for themselves. Either way, the GSE bears the default risk of the mortgages, which is the source of the recent crisis.

Congress thought that by assuming default risk on mortgage-backed securities, Fannie and Freddie would increase demand for those securities thus increasing the supply of capital available to mortgages, lowering mortgage interest rates and spurring home ownership.

The government never gave an explicit backing to the GSEs, but it was widely believed that Fannie and Freddie would not be allowed to fail. A private entity with government backing is a terrible idea because it creates significant moral hazard. Because such a structure “privatizes the profits, but socializes the losses”, its managers have an incentive to take a lot of risk to maximize the potential gains.

Fannie Mae and Freddie Mac have a dual comparative advantage:

  • The implicit government backing gives them lower bowering costs
  • Lower capital requirements allows them to take on more leverage

The value of these privileges is estimated to be worth between $122 and $182 billion according to a 2005 study by the Federal Reserve – mostly accruing to its shareholders and managers. Between 1998 and 2003, Fannie’s top fixed executives received $199 million! With so much at stake Fannie and Freddie built formidable lobbying machines and engaged in aggressive lobbying traditional banks are barred from undertaking.

These advantages allowed them to crowd out private mortgage lenders and concentrated all the risk in two institutions. This essentially guaranteed that they had become too big to be allowed to fail as they own or guarantee about half of the $12 trillion US mortgage market.

As house prices declined and home owners started to default on their mortgages, losses at Fannie and Freddie started to mount. Given how little capital they had, they started facing a liquidity crisis. Congress’ first reaction was to preserve the status quo and allow Fannie and Freddie to grow out of its problems. Last December the limit on the size of mortgages purchased by the GSEs was raised from $417,000 to $729,750. This July, legislation was passed allowing the US Treasury to extend credit to the GSEs or purchase equity in the company.

Allowing the GSEs to guarantee more mortgages only crowds out private banks and in turn encourages those to take more risk. Similar legislation which allowed insolvent S&Ls to survive during the 1980s forced healthier to take more risks and made the S&L crisis much worse than it would have been.

The July rescue attempt failed. The firms’ stock prices collapsed as investors feared they would be wiped out in a government rescue. This curtailed the firms’ ability to issue capital which in turn forced the government to rescue them. It probably would have been best for the agencies to be fully nationalized, but that that would have required an act of Congress. Instead Fannie and Freddie will be taken in “conservatorship”, a watered-down form of receivership, by their revamped regulator, the Federal Housing Finance Agency, until they are once again “sound and solvent”. They will have access to a loan facility secured by their assets. To avoid moral hazard, the Treasury will buy preferred shares as needed which will be repaid ahead of existing preferred and common stock.

The deal is not as bad for taxpayers as it could have been. In exchange for keeping the firms above water, the government will receive a $1 billion fee in preferred stock at no cost along with warrants giving it the right to 80% of the firms’ common stock at a nominal price. The two CEOs are being replaced and the organizations will no longer be allowed to lobby lawmakers.

It worries me that the eventual outcome for Freddie and Fannie has been left for Congress and the next administration to sort out. Winding them down might not be an option yet given how important they currently are to the mortgage market, but their business should eventually be privatized and split between a dozen or more banks with no government backing. In down markets a few of those may fail, but it would not undermine the stability of the mortgage market as a whole as the concentration in Fannie and Freddie has, especially given how little reserve capital they were allowed to hold. It’s a good sign that the Treasury plan calls for them to shrink by 10% a year starting in 2010 until they reach an undefined “less risky size”. This will allow banks and other financial institutions to expand their role in the mortgage market, ultimately resulting in a stronger mortgage finance system.

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  • dude .. as a new media entrepreneur, you might want to think about starting your own news outlet .. no joke .. i find you more interesting and greater on the credibility end than The Huffington Post

    If I were a brand or a premium service, I would advertise in the Grinda Times

    Just a thought 🙂

  • Very interesting post. I’ve encountered an interesting point of view from Alan Greenspan in the WSJ:

    “His quarrel is with the approach the Bush administration sold to Congress. “They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted — with necessary taxpayer support to make them financially viable — as five or 10 individual privately held units,” which the government would eventually auction off to private investors, he said.”

    http://online.wsj.com/article/SB121865515167837815.html?mod=hpp_us_pageone

  • LOL Huffington Post are loon bags so I’m not sure previous commentor gave compliment.

    Fannie and Freddie were clearly democrat party playtoys. Bush had been trying to fix these for the past 5 years but any governmental organ but was not able due to dem party resistance. “Nongovernmental-entities” is the punch line of a joke. Chris Dodd and Barnie Frank are the ones to google on this.

    Regardless of who is responsible your suggestiong of break up and sell off to a bunch of smaller entities is a good idea. Might need to shoot one and let them die just to demonstrate to the others that next time they are on their own!

  • An interesting comment by Warren Buffet himmself about Freddy and Fanny on CNBC on August 22nd 2008 (http://www.cnbc.com/id/26337298)

    BUFFETT: And they also had an added problem in that they had a dual mission. The government expected them to promote housing and the stockholders expected them to raise the earnings substantially every year. And as the years went by, they emphasized the latter more and more. They started talking about “steady Freddie,” and Fannie Mae said, `We’re going to increase the earnings at 15 percent a year.’ Any large financial institution that tells you that sort of thing is giving you a line of baloney. I mean, they may do it for a while, but when they can’t do it with operations, they do it with accounting and they cheat. And that’s what happened at both those places on a huge, huge scale. And we have this–they’re so wound up with national housing policy, that they’re a national problem and, with this dual situation, you know, Lincoln said a house divided against itself, you know, must fall. And they existed half-slave, half-free for a long time, and then the motivations became in conflict, and when they got on the 15 percent a year merry-go-round and said, you know, `We’re going to deliver earnings up every quarter, and we’ll meet them to the penny,’ when they can’t do it operationally, they do it with accounting

    BUFFETT: Well, it’s really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that’s $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

    QUICK: We talked earlier this morning about Fannie Mae and Freddie Mac and some of the major problems facing those two institutions right now. In your opinion do these stocks, you think, get wiped out?
    BUFFETT: Well, there’s certainly a reasonable chance of that because they wrote insurance at the wrong price. And if you write insurance and write–we write insurance at the wrong price, you know, we’re going to go broke. I mean, it–when you write insurance, you make a promise. In their case, they guaranteed the credit of trillions of dollars worth of mortgages and they charged a service fee for doing it–an insurance premium you can call it–and they got the wrong price for it. And then they–their other activity, which is to run a very large sort of hedge fund with a carry, where they lend money long and they borrow money in various ways, they had a spread on that. And that works fine as long as the spread’s maintained and they’ve done some things to protect that, but it doesn’t do well if the assets crumble on them, and they’ve had some crumbling. So they got into trouble the way people have historically got into trouble both in terms of running a carry trade and both in–and in terms of writing insurance at the wrong prices. And there is no easy cure. You can’t tear up your old insurance contracts. And they can–they keep existing because they’ve got the federal government behind them. And the federal government should be behind them, excluding the equity portion.

    QUICK: You own shares of Fannie Mae, Berkshire Hathaway did, up until when, about 2001?
    BUFFETT: We were the largest shareholders of Freddie Mac in the–in the United States, and around 2000 or 2001…
    BUFFETT: …it became so apparent to me that they were intent on trying to report quarterly gains to please Wall Street, and there are all–if you’ve got the government behind you and you can borrow money in unlimited amounts, you can report earnings for any given quarter that you want to. I mean, the chickens don’t come home to roost till later. And the management was intent on that. They started doing things on the asset side they shouldn’t have done, they made promises they shouldn’t have made, and so we got out.