Fannie Mae and Freddie Mac: How the Government has Warped the Housing Market for 80 years (Part 2)



Just in time for the second part of our discussion of Fannie Mae and Freddie Mac, the US Treasury has announced this week that it will spend $1 billion on blight in American neighborhoods.  The money will mostly be used to relieve some homeowners that are underwater in their mortgages to prevent them from foreclosing, but it will also continue the effort to demolish abandoned homes that hurt surrounding property values in at-risk neighborhoods.

I'll get to why this policy is tied to Fannie and Freddie at the end of the post.  First, let's jump back to where we left off, with the lead up to the 2008 financial crisis.

After Fannie and Freddie were officially privatized in the early 1970s, they remained government-sponsored entities (GSEs) which meant that though they were publicly traded companies, they enjoyed easy access to low-interest credit from the government, were the only 2 Fortune 500 companies exempt from publishing financial statements with the Securities and Exchange Commission (SEC), and were also exempt from local and state income taxes.  It was thus assumed, correctly as it turns out, that even if these organizations ran into trouble, the US taxpayer would be there to bail them out.

The true foundation of the 2008 crisis started in the 1980s when Fannie started issuing mortgage-backed securities, which are financial instruments used to bundle together lots of individual mortgages and sell them to other investors.  The up-side of MBSs was that it further infused capital into the housing market and reduced the risk of any individual foreclosure damaging the market by packaging geographically diverse sets of mortgages. The down-side of course was further separating the individual borrower from the direct lending institution which unknowingly created massive uncertainty about the value and security of mortgages. Unlike Freddie, which generally used MBSs to pass along this risk to investors (until the 1990s anyway), Fannie actually began to buy MBSs from other institutions and managed their own portfolio, taking on additional outside risk. This was largely in response to Wall Street firms doing the same, and, as a private organization responsible to shareholders, Fannie wanted to compete in a growing, lucrative market.

Again the idea with Fannie and Freddie was to increase capital flow in the housing market and, though they increased complexity and speculation in the market, it was a bi-partisan policy choice with broad popular support.  Increased complexity always means the increased risk of the unknown, but with the government implicitly backing Fannie and Freddie, the system churned on and on. According to the Congressional Budget Office, in 1981 Fannie and Freddie held $60 and $5 billion in mortgages respectively; by the late 1990s they held $114 and $21 billion.

It's also important to point out that many people with or without ties to Fannie and Freddie began to speak out about the mission creep of both organizations.  It was one thing to increase liquidity in the market to encourage homeownership, it was another to start, effectively, speculating on the housing market and amassing huge, profitable portfolios of unaffiliated mortgages.  This type of expansion would most certainly not have happened had they remained government agencies and, paradoxically, the market would probably not have formed such complexity had they not been created.  

The increasing securitization of the housing market on the one hand began to mirror the politicalization of housing on the other over the next decade.  Under President Bush (I) and President Clinton, Congress expanded Fannie and Freddie's mandate to offer affordable mortgages to lower-income Americans by requiring a certain percentage each year go to targeted demographics.   The policy goal in the Clinton administration was to get the homeownership rate to 70% by 2000, which came close at 66%.

BFFs over Fannie and Freddie (

BFFs over Fannie and Freddie (

There were dissenting opinions about expanding the market to riskier buyers, mostly based on the ideological belief that the government shouldn't interfere in the private market or that it would increase systemic risk given the uncertainty of these new buyer's abilities to pay their mortgages.  (Certainly, one can quibble with the idea that the private market would even exist without government intervention, but that's for another time.)

However, no one questioned the underlying assumption that homeownership was inherently better than renting or other forms of living arrangements.  The economy was so tailored to homeownership that it was not, nor is it now, really questioned.  Even if you take away the complete inevitability of the crisis and the billions spent in the bailout for a moment, you can faintly image how those funds, spent over decades, in more housing-neutral policies would have encouraged more investment in cities and sustainable communities that could be better adaptable to the world we live in today. It is also possible to consider how less segregated our neighborhoods could have been without so much public-private intervention. 

That debate didn't happen and instead, the call to expand mortgages to lower-income Americans continued with bi-partisan support. This led to steady rise of sub-prime mortgages, which are mortgages tailored to individuals with little or bad credit and reduced the amount of down payments. The introduction of these securities, and their attractiveness on the market, led to an explosion of irresponsible and predatory lending across the country in the early 2000s.

By 2006 and 2007, thousands of Americans had been missing mortgage payments and began defaulting in waves all over the country.  This can be attributed to explosive interest rates, stagnating wages, the real estate bubble, and a number of other factors. The main point is, the market wasn't working fine. What many observers in the financial world thought were small, localized market adjustments, quickly spread nationally as the confusion over the value of MBSs and who in fact was on the hook for these mortgages began to set in.  These instruments were supposed to reduce the risk of any individual foreclosures damaging the market, but instead hid the true risk of foreclosures on a systemic level from investors and policy makers - causing panic in the market that led all the way to Wall Street.

The financial crisis of 2008 was the worst economic downturn since the Great Depression, but that's really an understatement.  The complexity of the economy, now thoroughly globalized, was even greater than during the 1920s and 1930s and the scale of the potential collapse is still hard to fathom.  But we didn't have a depression because as opposed to the 1929 crash, the US Government - and US taxpayers - saved the day to the tune of about $620 billion in bailout money to major financial institutions - including $187 billion to Fannie and Freddie.

To be clear, Fannie and Freddie did not single-handedly cause the crisis; they were just two of the many badly prepared actors.  It is also still a matter of some debate as to how at-risk they were during the crisis.  At the time of the government take over in 2008, they had a positive net worth against their liabilities. What separated them from other institutions, and what evidently caused the government take over, was their asset-to-capital ratios, which were wildly out of line with other distressed banks. The fear was real that if mortgages kept defaulting at the levels seen in 2007-8, Fannie and Freddie (which owned or guaranteed 56% of American mortgages at the time) would be too over-leveraged to meet their obligations. Given how huge the two companies were, if they failed, there was no telling what would happen to the housing market or financial markets. Whether or not they actually were at-risk became secondary to the perception that they were.

Will the courts like Treasury's song and dance? (bloomberg)

Will the courts like Treasury's song and dance? (bloomberg)

Technically, the US government did not bailout Fannie and Freddie in September 2008 so much as make a massive invest in them, which partly explains the current lawsuit from shareholders. The nature of the takeover meant that the two companies received the $187b infusion of cash and transitioned into government receivership. The original deal called for Fannie and Freddie to pay 10% of their profits each quarter once they returned to profitability, which they did in 2012 (fueling the questions over how troubled they were). They remain in receivership to the present.

The Treasury revived the deal in 2012 to basically take all profits, which means that not only did the Treasury recapture its original $187b investment, but has actually profited to the tune of about $40b.  When challenged about the change in the deal, the US Treasury has claimed that it wasn't a bailout, but an investment, and their continued control prevents further risk in the housing market. We'll have to see how that plays out in court, but don't underestimate the sympathy courts have for shareholders.

If you're confused over why the US government - that started Fannie and Freddie in the first place, choose to privatize it, but still controlled it technically - is now getting sued for taking them back over, that's understandable.  You can make the argument that Fannie and Freddie never should have been privatized given the government's implicit guarantee (that became explicit in 2008) and their policy directives.  You can argue that they never should have existed in the first place.  You can argue that if they were privatized, they should never have still been GSEs.  You can argue that they should be broken up into multiple, smaller private companies to spread the systemic risk.  All of these perfectly valid arguments have been made, whether presently or in the past, but even in the wake of the 2008 crisis, that should have prompted these arguments to take center stage, the status quo (give or take what happens in the courts) will remain for the foreseeable future. The politics and economics don't lend themselves to practical change let alone radical change.

That brings us to the present, where not much has changed in the housing market. Indeed, there are even largely ignored new calls that Fannie and Freddie are at risk again. As mentioned at the beginning of this post, as part of the final distribution of funds from TARP, the 2008 bailout, the Treasury is spending $1b to help some homeowners with underwater mortgages and to even tear down abandoned homes to help with property values.  

This is small potatoes given the quiet, ongoing foreclosure crisis and overall affordability crisis across the country (and given the profits received from Fannie and Freddie), but it reveals the sad irony about the housing market and Fannie and Freddie. Institutions that were set up to help Americans own homes actually helped Americans lose their homes. And when the government had the choice between helping the institutions or individual Americans, it choose the institutions, and, really, their shareholders.

We could be having a national debate about housing policy as a result. We could question whether supporting homeownership is the right use of tax money. We could question if using tax dollars to intervene in the private market is appropriate at all. We could question if the private market can really address the the housing needs that we face.  But so far we haven't. So far our elected leaders have failed to adequately address the affordability crisis that many homeowners and renters face. The lessons of Fannie and Freddie are there to be learned, debated, and acted upon, but we have opted not to, and the crisis continues.