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

September 9, 2008

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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