Fannie and Freddie Are Largely Responsible for the Housing Bubble

Free Market economists lament the direct and indirect consequences of government interference in the marketplace. The decision in the early 1930's to have a GSE (Fannie Mae) guarantee private mortgages, instead of the individuals who took out the mortgages, is causing us a doozy of a problem here in the early 21st century. Compared to other government actions like providing public pensions (Social Security), and guaranteeing medical insurance for people over 65 (Medicare) the decision to create Fannie Mae seems relatively innocuous, but the indirect consequence of Fannie Mae (FNM) and Freddie Mac (FRE) was our most recent housing bubble.

It is now clear the Fannie Mae and Freddie Mac had a large and important role in creating the housing bubble that would not have been possible if they did not have the implicit (and it was more implicit than people thought) backing of the U.S. Government. Fannie Mae and Freddie Mac have an implied leverage ratio of anywhere from 60:1 to 200:1.

This article has a kooky, bomb shelter kind of conclusion about Fannie and Freddie, but the initial analysis is quite good.

If Fannie Mae and Freddie Mac were private corporations, they would not have been allowed this kind of leverage in the marketplace, and their borrowing costs would have exploded through the roof. This leverage is enough to make even the most hardened hedge fund manager blush. Furthermore it appears that even conservative Fannie/Freddie got caught up in the housing euphoria and let their lending standards lapse starting in our current decade. Countrywide (CFC) was firing mortgages through to Fannie at a very high rate. I'm guessing the mortgage feed from Countrywide to Fannie was computer to computer for mortgages.

What is clear now is that if Fannie/Freddie were not backed by the implicit faith and confidence of the U.S. government, they would never have been allowed to reach the leverage ratios that they were and could not have lent out the amount of money that they did. When excess lending hits a market like real estate, where 100% of the valuation is determined by the 5% of the houses that are on the market at the current time, bubbles occur.

Obviously Fannie and Freddie were assisted by sub-prime and the rating agencies (S&P, Moody's, Fitch) that rated a mortgage package backed by the over extended sub-prime consumer AAA when they won't give that same rating to 99% of corporate America. The end result of this government interference in the marketplace was our 2005-2008 housing bubble that is causing so many of disruptions now.

Fannie and Freddie have been in place for a long time. Don't ask me why the bubble occured now and didn't occur 15 years ago or 5 years in the future but I stand by my assertion that without Fannie/Freddie, the bubble would have been a sustainable rise in housing prices instead of the problem it became.  

What does this mean for Fannie, Freddie and Annaly (NLY) now? Clearly it doesn't take much of a writedown on 5.2 trillion dollars to wipe out any private equity that Fannie and Freddie may have. They have employees to pay and other corporate obligations that seem like a gnat compared with what happens if the sub-prime contagion moves even partially into their prime world as guarantor or holder of 5.2 trillion dollars of mortgages.

If the government takes over Fannie and Freddie, its action can only be to reign in excessive lending and re-institute conservative mortgage lending standards. Annaly seems to make money borrowing short and buying Freddie and Fannie debt long. I have every respect for Annaly's management and I am sure they are aware of this, but it's hard to see how a restricted Fannie/Freddie would not affect it.

Disclosure: The author holds no shares of FNM, FRE, or NLY.

Comments

[Dirk:]

Gee, FNM and FRE's market share drops like a rock durring the worst of the housing bubble, partly because of constraints due to their accounting problems, but largely because they required much tougher underwritting standards for mortgages than the crap paper that was packaged by the street (the beloved un fettered free market), and the fall of the housing market is all the fault of a decision made by FDR!

Take your ideological blinders off and actually think before you type.

2008 Jul 16 11:03 AM

[UncleLongHair:]

Correlation is not causation. FNM and FRE are impacted by the housing problems more than anyone else because they handled more mortgages than anyone else. If simply creating these entities "caused" the bubble, why haven't we had more bubbles over the past 70 years?

Other institutions are just as much to blame, if not moreso, than FNM and FRE, such as the reckless subprime lenders and ratings agencies that blessed their securities. Are FNM and FRE to blame for their actions as well?

>>> Clearly it doesn't take much of a writedown on 5.2 trillion dollars to wipe out any private equity that Fannie and Freddie may have <<<

The $5.2 trillion of mortgages held by FNM and FRE are not on their balance sheet, and thus can't be "written down".

Uncle

2008 Jul 16 11:12 AM

[KRF:]

What? Fannie and Freddie have always been limited to the conforming loan market, which for a long time during the "bubble years" was below $400,000 mortgages. Their risky stuff comes from their government required 25% "low and moderate income" housing goals. They had to buy riskier stuff because it was a requirement of the federal government to fulfill their housing "mission". They both also bought quite a bit of Alt-A mortgages (still within the conforming loan limit), so there is obviously more risk with those too. The REAL bubble maker was the advent of the Interest Only mortgage. This allowed people to buy much more expensive houses than they could previously because, heck, you only have to pay the interest -- and most of those came with intro teaser rates to make expensive house even more affordable (at least initially). Fannie and Freddie could not purchase these loans because their loan processing systems could not handle them. It's likely they wanted to be in that market, but thanks to their system limitations, they could not. It's the Interest Onlys that created the bubble and that's why it happened now and not in the previous 70 years. Duh.

2008 Jul 16 11:51 AM

[JMc:]

The GSEs did not force the rating agencies to mis-rate risk, did not force mortgage bankers and investment bankers to originate garbage in return for huge bonuses, did not force securitizers to spin tales of structuring the risk out of investments, did not force fund managers to buy toxic waste that they little understood, did not force regulators to dismiss concerns with blind faith in the marketplace and distribution of risk. What the GSEs did was expose the taxpayers to this mess even as they avoided most of the sub-prime waste. Perhaps it would have been better if they were still government entities and the taxpayers were clearly on the hook. But to avoid charges of "socialism" we moved them into government sponsored SIVs and paid foreign investors a premium to help us pretend that the weren't really backed by the Treasury (but wink, wink don't worry).

2008 Jul 16 12:19 PM

[Thomas J. G...:]

Dirk - This is an ideological statement. I am sensitive to "creative destruction" that I see. If free markets cause too much disruption in people's lives, then alternative methods of economic organization should be considered, but it has to be a free market. One thought I had about "why now", maybe fannie/freddie works with flat to rising housing prices, and doesn't work when prices decline at the national level. maybe fdr did signal this problem through to us. it also doesn't seem unreasonable, when looking for root cause to the housing bubble, to look at the lenders who packaged more than 1/2 of the mortgages in the country. In terms of the economic analysis in this article, I'm confident that Milton Friedman, with his internet connection in heaven, would agree with most of it.

Uncle,

My understanding is that if fannie issues a hundred million dollar bond backed by conforming mortgages, and some of those mortgages defaulted or had loss of principal, fannie would have to make good for that. That's what the "guarantee" is. That is a potentially large liability. Am I wrong?

2008 Jul 16 12:53 PM

[whtamess:]

What a bunch of CRAP... obviously you have no idea how a bank lends money. If it weren't for these GSE's there would have been no money to lend to people to buy homes... they would have run out of money you moron. They created liquidity so banks could continue to lend and people could buy homes at reasonable rates.

What happened here was some nitwit coming up with accounting rules that caused so many asset problems and people like this that write articles that downgrade the stock that in turn puts a crack in market and affects our dollar nationally and internationally.

2008 Jul 16 03:47 PM

[John Stiles:]

Maybe I'm naive, but it seems to me that the housing bubble resulted more from over hyped demand that can be traced directly to: a) the easy credit that the Fed maintained in order to effect a recovery from the 2000 Tech melt down and 9/11 terrorist attacks and b) a bias in Federal tax law that encourages home ownership by allowing deductions for mortgage interest but not rent. Markets will always go to extremes. Bubbles are folowed by busts. Value investors understand this concept and will be the first to begin picking up the pieces.

2008 Jul 16 03:54 PM

[utahcoyote:]

This is not true. Despite the reckless disregard with which elements of FEMA and GM were combined to operate Fannie and Fred!

The cause of the housing bubble was created beginning in 2004 when - following two years of bubble-spans solution for the ".com" era of irrational exuberance, and Widjit's "go shopping" directive after 9/11 to create a low interest rate environment and making cheap dollars available, Bear Stearns, Citibank, et al discovered a product that offered "investors" 7-9% "AAA" rated yield in a 3% interest rate world - CDOS, MBS, ABS, etc.

Most of these were operated off balance sheets with SIVs and what not! Wide-stance Angelo at Countrywide, etc. existed to meet this insatiable and artificial demand for yield in which one could borrow at 4 and make 8% - the closest thing to a free lunch one can get. (Also don’t forget the carry trade with the Japanese Yen, which instead of housing, put the money in the S&P etc.)

Fannie and Freddie were not part of this game. But then, anyone who expected competence from the government to be involved in the market, and invested in them, are entitled to and deserve what they get! Congress is not Canute, and ultimately will not stop the tide.

Once this stupidity ends, perhaps we can get back to real world and real money for real work. The era of prospectuers will be over. But ... not for a long time!

2008 Jul 27 11:16 PM

[Suni:]

The cause of the housing bubble or the other failures in the past few years is basically due to manipulation, greed and incompetent people running the Fannie Mae, Freddie Mac, Enron and other BIG organization. It doesn't matter how they did it, what matters is that we are repeating the same mistake now and helping these con artists to rip us again.

Look at the Executive Compensation Report in Monday's business section; Mr. Syron of Freddie Mac was rewarded $8.3m. in stock options award to provide "improved customer service" but in his own organization an employee will get slightly better than minimum wages for providing that type of service! In 2007 Mr. Richard F. Syron of Freddie Mac earned 14.5 million and Mr. Daniel Mudd of Fannie Mae received $14.2 m. including 2.2 million “performance bonus” for destroying these two huge GSEs. An employee of any well run company will be fired if s/he create a financial mess (cooking accounting books) but these executives first created these problems (destabilize the mortgage market by manipulation) and then they are helping or in other words showing their "leadership in subprime crisis" by playing important "role in stabilizing the mortgage market"! All they are doing is filling their pockets again.

If they had even mediocre management skills or little street smartness they would have seen the mess they were creating. Armed with big high and mid level management staff and with millions of dollars spent on management training like “six sigma” all they learned was how to delegate duties and responsibilities to someone else with no accountability!

God Bless Our Country!

2008 Jul 29 12:59 AM

[Thomas J. G...:]

Suni, you are on to something! There have been academic studies of where the benefits of the GSE's go. The conforming mortgage borrower gets 30 to 40 basis points of mortgage benefit (hardly seems worthwhile for that, just let the private sector do it). The rest goes (went) to the shareholders and the employees as you have mentioned above. Speaking of the management, it's ironic that they let the leverage/situation get so out of hand. They had cushy jobs making very good money and some people are saying if the treasury/the fed steps in, the shareholders get 0 and there will be new management that works for the government. ... Flash

2008 Jul 29 08:08 PM

[E Nuff Sed:]

Fannie and Freddie (GSE's) guaranteed mortgage backed securities (MBS) are held to maturity - so day to day market prices of the the MBS's should not matter, unless they are traded. You using day to day prices coming out of a nervous market to calculate leverage.

Given that the MBS's are now rock solid - (the "implicit" govt. backing) this leverage should not matter.

2008 Aug 18 04:47 PM