Fannie and Freddie Are Largely Responsible for the Housing Bubble

Includes: FMCC, FNMA, NLY
by: The Market Flash

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 (NYSE: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.