“Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac…Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules. The fair value of Fannie Mae’s assets fell 66 percent to $12.2 billion, and may be negative next quarter.
Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer…”
Former St. Louis Federal Reserve President William Poole, July 9, 2008
The story of Fannie and Freddie is a subplot in a greater drama that continues to play itself out on the stage of American politics. It is the story of individual freedom versus our collective welfare. It is the story of the constant tug between the excesses of the free market and moderating forces of government regulation. It is the story of the ebb and flow of regulation and deregulation.
The Roaring 20’s – Free Market Excesses set the Stage for Government Intervention
The housing market of the 1920’s the current housing bubble have much in common. The 1920’s experienced a similar boom in both building and price appreciation. As the boom developed, underwriting standards for mortgages declined in direct proportion to increasing home prices.
The loan market of the 1920’s didn’t have the adjustable rate reset that triggered the end of the current housing bubble. It had something much worse, the balloon payment. The typical mortgage loan of the 1920’s had a term of five years or less with no payment of principal until the loan matured and a large balloon payment was due. However, instead of making the balloon payment, during the easy credit environment of the 1920’s, many of these loans were just rolled over and refinanced. As long as interest rates were stable, and incomes and home prices were increasing, this free market party would continue.
This easy credit party environment would set the stage for a 1930’s housing hangover when homeowners found themselves unable to withstand the substantial decline in income and home prices of the Great Depression.
The New Deal – The Free Market takes a back seat to Government Backed Enterprise and Regulation
For the American mortgage, the story of Fannie and Freddie finds its roots in the excesses of the 1920’s and begins with FDR’s New Deal programs to alleviate the Great Depression. In 1934, Congress passed the National Housing Act to strengthen a deeply troubled housing market consumed by a flood of foreclosures. Initially, this act created the Federal Housing Administration (FHA). Deviating from the short term, interest only, balloon payment loans of the 1920’s, FHA-insured loans were fully amortized principle and interest loans with 15 or 30-year terms. When the program began, FHA loans were limited to $16,000 or less (compared to a median U.S. house price of $5,304) with a maximum loan-to-value ratio of 80 percent and a maximum interest rate of 5%. In 1938, the act was amended to create the Federal National Mortgage Association, whose abbreviation would lead us to the Fannie Mae nickname.
Fannie Mae was designed to help mortgage lenders gain access to capital for mortgage loans. An important element of this legislation was to make mortgage funds available to more Americans by protecting lenders from the risk of default. In its earliest days, Fannie Mae nationalized the mortgage industry by creating the first mechanism in America for selling individual (FHA insured) mortgages into a secondary market embedded in the balance sheet of the U.S. Government. The formation of this secondary market, increased the supply of money available for mortgage lending and new home purchases.
When the FHA and Fannie Mae were created, the housing industry was is severe crisis:
- Two million construction workers had lost their jobs.
- Approximately one-half of urban houses with an outstanding mortgage were in default
- Housing finance was a fragmented, inefficient and illiquid. Mortgage rates varied considerably from region to region. In some economically distressed regions there were simply no funds available.
- Terms were very difficult to meet for homebuyers seeking mortgages.
- Lending institutions would issue a mortgage, collect payments, and file the mortgage away until the principal was paid off. A lack of available, consistently priced capital put a hard ceiling on the number of new mortgages that could be issued.
- Mortgage loan terms were limited to 50 percent of the property’s market value. Borrower’s were faced with a 50% down payment and a repayment schedule spread over three to five years and ending with a large balloon payment.
- America was primarily a nation of renters. Only four in 10 households owned homes.
From 1938 to 1968, the secondary mortgage market in the United States was an exclusive playground of Fannie Mae. In 1968, Lyndon Johnson was fighting a war in Vietnam and attempting to build the Great Society. To help balance the federal budget, and clear Fannie Mae from the government’s balance sheet Johnson spun Fannie Mae off as a private corporation and the U.S. ceased to be an official guarantor of FHA issued mortgages. However, Fannie Mae was still a Government Sponsored Enterprise [GSE] with advantages that no truly private enterprise could hope to enjoy.
As a GSE, Fannie Mae (and later Freddie Mac) would enjoy a guaranteed line of credit with the U.S. treasury. This guarantee, coupled by the perception that federal money would be used beyond the extent of the credit limit if they were to have any financial difficulty, allowed GSE’s to achieve lower borrowing costs. The perception that GSE’s enjoyed “the full faith and credit” of the U.S. Government allowed Fannie and Freddie to issue debt at terms nearly on par with the U.S. Treasury. In addition to their other perks, GSE’s are also exempt from state and local income taxation and from SEC filings.
In 1970, Freddie Mac would join the GSE party. The Federal Home Loan Mortgage Corporation (Freddie Mac) was created as an additional private entity to break Fannie Mae’s monopoly and to expand the secondary market for home mortgages.
Together, Fannie Mae and Freddie Mac essentially act as financial pipelines, linking the bond markets from lenders to homeowners. They raise funds by selling mortgage debt securities to bond investors and guarantee principal and interest payments on the notes. Based on the American dream of home ownership, Fannie and Freddie have been wildly successful. Taken together they have been the primary engine that helped to create a homeownership rate in America of nearly 70%.
However, in the opinion of many, the invention of the Government Sponsored Enterprise embodied in Fannie and Freddie, was just a formula for privatizing profit and socializing loss.
The Post New Deal Mortgage Market Settles into a Pre Boomer Equilibrium
By the 1970’s, the mortgage industry had became clearly defined. Conventional mortgage loans were the domain of savings-and-loan associations (S&Ls), and government mortgage loans (FHA, VA) were the domain of mortgage bankers.
The mortgage business was conservative, stable, highly regulated, and predicable. Loan orgination was still local and banks and S&L’s only funded loans in their home state. Federal Regulation Q regulated interest payments on deposits that were then used to fund mortgage loans. Banks and S&L’s made 30-year fixed rate loans at 8 to 8-1/2% and funded those loans with deposits for which they paid 5 to 5-1/4%. This was still primarily an originate-and-hold business model that was dominated by FHA and VA insured loans. Banks and S&L’s onlyh sold a small percentage of their loans. The GSE secondary-mortgage market was still evolving and Freddie and Fannie were just beginning what would become a stunning expansion.
The Free Market Strikes Back – The Impact of the Baby Boomer and the Invention of the Collateralized Mortgage Obligation and Private Sector Secondary Market
In 1977, Lewis Ranieri would invent a new form of the mortgage backed security called the Collateralized Mortgage Obligation [CMO]. Ranieri was a free market success story of ingenuity and hard work. He had worked his way up from the mail room to Saloman Brothers mortgage trading desk at a time when the flow of capital into the mortgage market was beginning to show signs of stress.
In the mid-1970s the baby boomer generation entered the raise-a-family stage of their lives, and the demand for new homes caught the mortgage industry by surprise. Banks and S&L’s found themselves unprepared for the sudden demand for new mortgages. The old business model of using borrowed money from depository accounts to originate fixed-rate loans, was no longer providing enough capital to fund the volume of new loans.
Ranieri saw an opportunity and hired PhDs who developed a new mortgage backed security known as the Collateralized Mortgage Obligation. A CMO slices and dices pools of 30-year mortgages into collections of 2-, 5-, and 10-year bonds that would appeal to a wider range of investors. The new baby boomer homeowners of a sprawling suburbia could now tap funds from New York, Chicago, London, Beijing, Dubai, Moscow, or Tokyo. [See “Recipe for Disaster: The Formula That Killed Wall Street”]
Based on Ranieri’s work, in 1977, Salomon and Bank of America Corp. developed the first private (non GSE) mortgage-backed security (MBS). These CMO bonds pooled thousands of mortgages and passed homeowners’ payments through to investors. It would not be easy. At the time, these new financial instruments faced significant legal and tax barriers and were only viable in 15 states.
Deregulation and tax relief would come in the form of the Tax Reform Act of 1986 and soon after, private MBS trading would explode with Saloman Brothers dominating the market. The financial instrument Ranieri created would eventually funnel trillions of dollars into the housing market with some extraordinary unintended consequences.
Freddie Mac is Cut Loose and Enters the Derivatives Market
In 1989 Freddie Mac was privatized as a GSE with the same sweetheart arrangement as its older cousin Fannie. Soon after, in the 1990’s, Freddie’s management would step to wild side and enter the derivatives market. In the hopes of greater profit, Freddie starts to hold rather than pass on the risk and securitize its mortgage portfolio. To mitigate this increased risk, they use early “interest rate swaps” to hedge against interest rate fluctuations.
The moral hazard of “privatized profit” and “socialized loss” is officially put in play as Freddie deviates from its original government charter.
Free Market Excess and Greed Ride the Sub Prime Express
Sub prime mortgages had been lurking around around the fringe of the market since the 80’s, but it was not until 1995 that the subprime mortgage market would suddenly explode with the sudden rise and investor appetite for subprime mortgage backed securities. Investors around the world would be seduced by the sophisticated mathematical models and apparent default protection of these newly minted AAA rated securities. Huge bonuses would flow to the corner offices of Wall Street while at the same time, the back offices would be labeling these instruments as “toxic waste”.
In 1996, Countrywide would enter the subprime market with the launch of its Full Spectrum Lending Division and the Originate-Forget-and-Sell business model of mortgage lending would blossom like an invasive weed.
In 1998, a minor subprime mortgage crisis would be triggered by Russian debt default and the resulting short term contraction of the subprime MBS market. However, the market would soon be back to the races as lender and borrower greed would power us to the mother of all housing bubbles.
Fannie and Freddie behave like Hedge Funds and Invest in the Subprime Market
Beginning in 1997 and 1998, Freddie and then Fannie began buying mortgage backed securities backed by others. Like hedge funds using the “carry trade” they used their cheap financing to buy higher yielding and higher risk assets that exposed them to the subprime market. By 2007, the two giants would own $385 billion of these assets. Not large in comparison to the their total obligations, but very large in comparison to their total equity.
The moral hazard increases as the management seeks greater profit and rock star compensation. However, the implied backing of the U.S. Government still provides a tacit safety net for reckless behavior.
Deregulation Gramm tears down the last Post Depression Firewall
The passage of the 1999 Financial Services Modernization Act, under President Clinton was celebrated in a Wall Street Journal editorial as an end to “unfair” restrictions imposed on banks during the Great Depression. Co-sponsored by Phil Gramm, the Act repealed the 1933 Glass-Steagall bank reforms that created firewalls between commercial banks, investment banks, insurance companies, and securities firms. The Act would set off a wave of merger madness creating a whole new class of too-big-to-fail companies like Bear Stearns that would join the ranks of GSE’s embedded with the potential moral hazard of “privatized profits” and “socialized losses”.
Conglomerate financial institutions with inordinate political and economic power could now originate a loan in one division, package and securitize in another, and sell mortgage backed securities in third. All would be well as long as home prices continued to appreciate.
The American Homeownership Dream morphs into the Home-as-ATM Fantasy
Sometime after the baby boomers entered the home market, the American Homeownership Dream changed. The American ideal of “home” as a sanctuary to raise a family and retire a mortgage morphed into some kind of turn and churn investment vehicle. Initially, the home was seen as a viable retirement vehicle. But as real wages stagnated, and credit cards were maxed, the only option left to fund the consumer economy of granite countertops and SUV’s was to turn our homes into ATM machines.
The easy flood of MBS fueled liquidity, combined with low federal fund interest rates, teaser 2/28 Adjustable Rate Mortgages, and the perception that homes would always increase in value, would paper over the bursting dot-com bubble with mortgage equity withdrawals.
Mortgage Equity Withdrawal [MEW] Funds Bush Recovery
Incredibly, home re-financing would be the engine behind the so called Bush economic recovery as we extracted “value” from our homes to fund the consumer economy and continue to live beyond our means. Since nothing was added to create this “value”, we were just delaying an eventual day of financial reckoning.
The equity withdrawal binge would peak at $225-billion in the first quarter of 2006 and begin to crash in 2007 as the wheels came off the home appreciation express.
The Housing Price Bubble Bursts
Rising asset prices can make any fool look like a genius. In the case of our homes, rising prices meant originators could lend money to people that could barely afford the teaser rate and pass on the loan the same day to and unsuspecting investor in the MBS market. In a perfect world, the buyer could either refinance or cash out two years later after his equity had increased by 10 or 20%. The same lender could float a no-documentation “liars loan” to a speculator who could flip the property in a year or two for an easy 25% capital gain. If she was really good, the same lender could talk a prime loan couple into a high fee subprime ARM with a crazy low teaser rate and write them a cashout-refi check so they could blow their retirement nest egg and lay the groundwork for losing their home in one simple closing ceremony.
There was little risk in any of this free market magic as long as prices kept rising. Rising prices insulated the lender, the borrower, the MBS packager, the broker, the monoline insurer, the rating agencies, Fannie and Freddie, and the investor.
However, after the first waves of adjustable rate mortgages hit their 2-year reset buttons and millions of foreclosed properties choked up the nation’s inventory, prices began to fall, and as they always do, the bubble burst.
As home prices began to fall, the market for subprime mortgage backed securities evaporated and the Originate-Forget-and-Sell business model imploded as the “sell” part of the equation simply disappeared. The speed at which this happened was breathtaking. In 2007, 150 mortgage related businesses failed and 2008 is on track to be even worse. At first we were told the housing crisis was “contained” and limited to the subprime sector.
However, as events unfolded, the housing crisis turned into the credit crisis and both the Fed and the U.S. Treasury began to take extraordinary steps to avoid a meltdown. Countywide was deemed too symbolic to fail, and a backdoor bailout in the guise of an acquisition by Bank of America was bankrolled by the Fed. Bear Stearns was deemed too big to fail, and to avoid a potential meltdown in the unregulated $500-trillion dollar derivative market, Bear became the subject of another government brokered “acquisition” by J.P. Morgan.
The problem that was once contained and only estimated to cost financial institutions $400-billion is now grown in magnitude to an estimated $1.6-trillion and includes predictions of over 100 bank failures, an insolvent FDIC, and the very real insolvency and bailout of Fannie and Freddie.
Data Source: http://www.mortgagedaily.com, The Mortgage Graveyard
The Fall of Fannie and Freddie and the return of Government Regulation and Enterprise
Fannie and Freddie were not supposed to fail. They were well regulated and they didn’t underwrite high risk loans. They were so dominant in the market that they would eventually finance over $5-trillion of the $12 trillion U.S. mortgage market. They are also highly leveraged and bursting bubbles do not play favorites, especially with GSE’s immense exposure to a single market. In the context of declining home values, even good loans go bad. In the case of Fannie and Freddie, at the end of 2007, when you’re leveraging $5.2 trillion of debt and guarantees on top of $83.2 billion (65 to 1) in core capital, it doesn’t take much bad news to tip you over into insolvency.
Since the failure of Fannie and Freddie would make the failure of Bear Stearns look like child’s play, the Fed and U.S. Treasury are proposing another bailout disguised as a government “investment”. Implying a limitless supply of taxpayer dollars, Secretary Paulson has proposed that the Treasury either purchase Fannie and Freddie shares and/or grant them loans at very low interest rates. In return, Paulson proposed additional oversight, saying that the Treasury would assume a “consultative role” within the GSE’s. The Federal Reserve announced it would open it’s printing press to the two mortgage giants that now represent 80% of the new mortgage market. Fannie and Freddie will both be able to use the Fed’s “discount window” borrow money at 2.25%.
The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press. – The Economist July 17, 2008
Coming Full Circle – A New “New Deal” and another Installment of the American Dream?
The deregulated excesses of the 1920’s housing market, contributed to the Great Depression and led to the highly regulated mortgage and loan framework of the New Deal. Less than 80 years later we have managed to deregulate and tinker our way into a housing crisis that looks strangely like 1929. Once again we are looking to the government to moderate and save us from the excesses of an unregulated free market. At a minimum, Fannie and Freddie will become much less private. In the extreme, they may even be nationalized, adding another $5-trillion to our national debt.
In the greater drama between the forces of the free market and moderating forces of government regulation, the next act is bound to be one of greater regulation and government intervention.
Another sub plot is the ever changing form of American Homeownership Dream. As the dust settles on over 2-million foreclosures and the home ATM is swept into the dustbin of history, what form will the next version of dream take?