Making Sense
The Bailout of Fannie Mae and Freddie Mac
This article is from the September/October 2008 issue of Dollars & Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org/archives/2008/0908moseley.html
This article is from the September/October 2008 issue of Dollars & Sense magazine.
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On Sunday, September 7, Treasury Secretary Henry Paulson announced that the U.S. government was taking control of Fannie Mae and Freddie Mac, the two giant home mortgage companies, which together either own or guarantee almost half of the mortgages in the United States. This takeover stands in striking contrast to the generally laissez-faire philosophy of the U.S. government, especially the Republican Party. Why did Paulson take this highly unusual action? And what will be the future of Fannie and Freddie? To delve into these questions is to underscore the critical fault line between private profits and public aims—in this case, the aim of making homeownership affordable—a fault line that ran right through the hybrid structure of Fannie and Freddie.
A Brief History
Fannie Mae (short for the Federal National Mortgage Association) was created as an agency of the federal government in 1938 in an attempt to provide additional funds to the home mortgage market and to help the housing industry recover from the Great Depression. Fannie Mae purchased approved mortgages from commercial banks, which could then use the funds to originate additional mortgages. It continued to fulfill this function on a modest scale in the early postwar years. Fannie Mae was privatized in 1968, in part to help reduce the budget deficit caused by the Vietnam War (a short-sighted goal, if ever there was one). In 1970, Freddie Mac (Federal Home Loan Mortgage Corporation) was created as a private company in order to provide competition for Fannie Mae. Chartered by the federal government, both are (or were, until the takeover) so-called government-sponsored enterprises: private enterprises whose main goal is to maximize profit for the shareholders who own them, but also quasi-public enterprises with a mandated goal of increasing the availability of affordable mortgages to families in the United States. In the end, this dual mandate proved to be untenable.
In order to obtain funds to purchase mortgages, Fannie and Freddie sell short-term bonds. In other words, their business plan involves borrowing short-term and lending long-term, because interest rates are higher on long-term loans than on short-term loans. However, such “speculative finance” is risky because it depends on the willingness of short-term creditors to continue to loan to Fannie and Freddie by rolling over or refinancing their short-term loans. If creditors were to lose confidence in Fannie and Freddie and refuse to do so, then they would be in danger of bankruptcy. This is what almost happened in the recent crisis.
Beginning in the 1970s, Fannie and Freddie began to develop and sell “mortgage-backed securities”—hundreds of mortgages bundled together and sold to investors as a security, similar to a bond. They also guaranteed these securities (so that if a mortgage defaulted, they would repurchase it from the investors) and made money by charging a fee for this guarantee (like an insurance premium). This major financial innovation enabled the two companies to buy more mortgages from commercial banks, thereby increasing the supply of credit in the home mortgage market, which in turn was supposed to push mortgage interest rates lower, making houses more affordable. These early mortgage-backed securities consisted entirely of “prime” mortgages—that is, loans at favorable interest rates, typically made to creditworthy borrowers with full documentation and a substantial down payment.
The securities that Fannie and Freddie sold were widely perceived by investors to carry an implicit government guarantee: if Fannie or Freddie were ever in danger of bankruptcy, then the federal government would pay off their debts (even though this government guarantee was explicitly denied in legislation and in the loan agreements themselves). This perceived guarantee enabled Fannie and Freddie to borrow money at lower interest rates because loans to them were viewed as less risky.
In the 1980s, Wall Street investment banks also began to package and sell mortgage-backed securities. In the 1990s and 2000s, these “private label” mortgage-backed securities expanded rapidly in volume and also in reach, coming to include “subprime” mortgages—loans at higher interest rates with less favorable terms, geared toward less creditworthy borrowers and typically requiring little or no documentation and little or no down payment.
The subprime innovation was entirely the work of the investment banks; as of 2000, Fannie and Freddie owned or guaranteed almost no subprime mortgages. This innovation greatly increased the supply of credit for home mortgages and led to the extraordinary housing boom of the last decade, and also eventually to the crisis. As a result of these changes, the share of mortgage-backed securities sold by Fannie and Freddie fell to around 40% by 2005.
In the recent housing boom, the companies—especially Freddie—began to take greater risks. While continuing to bundle prime mortgages into securities and sell them to investors, Fannie and Freddie began to buy mortgage-backed securities issued by investment banks, including some based on subprime and Alt-A (between prime and subprime) mortgages. Why did they begin buying as well as selling mortgage-backed securities? Buying these private-label securities gave Fannie and Freddie a way to get in on the subprime action—while still avoiding direct purchases of subprime mortgages from the banks and mortgage companies that originated them. It was a way both to increase their profits at the behest of their shareholders, and, in response to pressure from the government, to make more mortgages available to low- and middle-income families. Of course, it also opened them up to the risks of the subprime arena. Moreover, the prime mortgages they continued to buy and guarantee were increasingly at inflated, bubble prices, making them vulnerable to the eventual bust and the decline of housing prices.
Anatomy of a Crisis
When the subprime crisis began in the summer of 2007, Fannie and Freddie at first appeared to be relatively unaffected, and were even counted on to increase their purchases of mortgages in order to support the mortgage market and help overcome the crisis. Congress facilitated this by relaxing some of its regulations on the two companies: the maximum value of mortgages that they could purchase was increased substantially; their reserve capital requirements, already much lower than for commercial banks, were reduced further; and restrictions on their growth were lifted. As a result of these changes and the drying up of private label mortgage-backed securities, the share of all mortgage-backed securities sold by Fannie and Freddie doubled to approximately 80%. Without Fannie and Freddie, the mortgage and housing crises of the last year would have been much worse.
As the overall crisis unfolded, however, the financial situation of Fannie and Freddie deteriorated. Delinquency and foreclosure rates for the mortgages they own or guarantee, while lower than for the industry as a whole, increased rapidly and beyond expectations. The two companies together reported losses of $14 billion in the last year. Their actual losses have been much worse. As of mid-2008, the two had lost about $45 billion due to the decline in the value of their mortgage-backed securities, mostly those backed by subprime and Alt-A mortgages. But by labeling that decline “temporary,” they could leave the losses off their balance sheets. If these losses were counted, as they should be, then Freddie’s capital would be completely wiped out (a value of -$5.6 billion), and Fannie’s would be reduced to a razor-thin margin of $12.2 billion (less than 2% of its assets), likely becoming negative in the coming quarters. In addition, both Fannie and Freddie count as assets “tax deferred losses” that can be used in future years to offset tax bills—if they make a profit. Without this dubious (but legal) accounting trick, the net assets of both Fannie and Freddie would be even lower, -$20 billion and -$32 billion respectively.
The financial crisis of Fannie and Freddie worsened in early July. The price of their stock, which had already fallen by more than half since last summer, declined another 50% in a few weeks, for a total decline of over 80%. Fear spread that Fannie and Freddie’s creditors would refuse to roll over their short-term loans to the two. If that were to happen, then the U.S. home mortgage market and the housing construction industry probably would have collapsed completely, and the U.S. economy would have fallen into an even deeper recession. Furthermore, approximately 20% of the mortgage-backed securities and debt of Fannie and Freddie are owned by foreign investors. Mainly these are foreign governments, most significantly China. If these foreign investors became unwilling to continue to lend Fannie and Freddie money, this would have precipitated a steep fall in the value of the dollar which, on top of recent significant declines, would have dealt another blow to the U.S. economy. Clearly, the potential crisis here was serious enough to spur government action.
In late July, Congress passed a law authorizing the Treasury to provide unlimited amounts of money to Fannie and Freddie, either by buying new issues of stock or by making loans, and also to take over the companies in a conservator arrangement if necessary.
Government Takeover
Through August the financial condition of Fannie and Freddie continued to deteriorate (especially Freddie), and confidence in their ability to survive waned. Foreign investors in particular reduced their purchases of the companies’ debt, and mortgage rates increased. The Treasury concluded that it had to implement a takeover in order to reassure creditors and restore stability to the home mortgage market. The Treasury plan has three main components:
- It commits up to $200 billion over the next 15 months for purchases of preferred shares of Fannie and Freddie as necessary to keep the companies solvent;
- It establishes a special lending facility that will provide emergency loans in case of a liquidity crisis;
- It commits to purchase unspecified amounts of Fannie and Freddie’s mortgage-backed securities “as deemed appropriate.”
The day after Paulson’s announcement, William Poole, ex-president of the Federal Reserve Bank of St. Louis, estimated that the total cost to taxpayers would be in the neighborhood of $300 billion.
The top managers and the boards of directors of both companies will be dismissed and replaced by new, government-appointed managers. Other than that, the Treasury hopes that day-to-day operations at Fannie and Freddie will be “business as usual.” They will continue to borrow money from creditors, now reassured by the government’s intervention and more willing to lend to them, and they will continue to purchase and guarantee prime mortgages. In fact, Treasury Department plans call for the volume of mortgages purchased by the two companies to increase over the next year in order to push the supply of mortgage loans up and mortgage interest rates down.
The Treasury plan is a complete bailout of the creditors of Fannie and Freddie, who will be repaid in full, with taxpayer money if necessary. In contrast, owners of Fannie or Freddie stock will lose to some degree: dividends will be suspended for the foreseeable future, and their stock is now worth very little. But their stock was not expropriated. Nor was it wiped out entirely; it could regain value in the future as the home mortgage market recovers. Without the intervention, both companies would have gone bankrupt and the stockowners would have lost everything. So the intervention does represent at least a modest bailout for shareholders.
The most controversial issue in the months ahead will be the future of Fannie and Freddie. Should they become public enterprises permanently? Should they be re-privatized? Should they be sold off in pieces and cease to exist? Secretary Paulson made it clear that the government’s current conservatorship is a holding action, and that decisions about the companies’ ultimate status will only be made once the next administration and the next Congress are in office. Paulson said that Fannie and Freddie’s current structure is unworkable because of its dual and conflicting goals of making housing affordable and maximizing profit—a radical statement, if you think about it! And he suggested that the two should either be fully public enterprises, or else they should be fully private enterprises without any government backing.
In the upcoming debate, the left should advocate forcefully for a public home mortgage agency, one whose sole purpose is to provide affordable housing without the conflicting purpose of maximizing profit. This would stabilize the home mortgage market and help it avoid the boom/bust cycle of private mortgage markets that has brought on the current crisis.
More fundamentally, because decent affordable housing is a basic economic right, providing credit for home purchases should be a function of the government rather than of private businesses whose primary goal is maximum profit. The provision of credit for housing should not be an arena where enormous profits are made, as has been the case in recent years. Without these huge profits, mortgages would be cheaper and houses more affordable. Plus, the kinds of fraudulent lending practices that played a significant role in the recent housing boom would be minimized.
With the presidential election just weeks away, the crisis of Fannie, Freddie, and the whole home lending market is poised to become a major campaign issue. McCain has said that he wants Fannie and Freddie to “go away”—i.e., to be broken up and disappear, leaving the mortgage market entirely to private enterprises. Obama has emphasized the conflict between the public aim of making housing widely affordable and the private aim of making a profit, but so far he has not come down on one side or the other. Now he will have to decide. I hope that he will be a strong advocate of a public home mortgage agency, and I think this would help him to get elected.