Nationalization of the U.S. Mortgage Problem

This is a topic I first broached in May. The United States has a mortgage problem in that house prices have fallen so much and the financial sector is so leveraged that the US faces systemic banking risk from a vicious circle in the mortgage sector. (I normally might have said 'negative feedback loop,' but my good reader dearieme pointed out I was misusing the term)

This circle leads from house price declines to foreclosures to bank losses to bank de-leveraging and credit tightening leading to more house price declines and on it goes.

Enter Hank Paulson.

By taking over the Government Sponsored Enterprises (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE), Paulson can use the two companies, now under government control, to provide fresh liquidity to the mortgage market.

Roots of mortgage nationalization in depression

You see, that is why Fannie Mae, and later Freddie Mac, were created in the first place. On Fannie's website, it says:

Fannie Mae was created in 1938, under President Franklin D. Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America.

The government established Fannie Mae in order to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home.

(Fannie Mae)

In essence, the Great Depression caused great hardship for Americans because of the destruction of America's financial system after a wave of bankruptcies in the banking sector. Let's go back to that painful period of American history.

Bank runs

During the Great Depression, the United States suffered from a similar difficulty of high financial sector debt (see chart below for statistics on debt increase since WWII)coupled with asset losses, eroding banking capital. The result was a loss of confidence in the banking system, causing people to withdraw their deposit money from a number of institutions. These deposit withdrawals created rumor mills that whipped the public into a panic whereby certain banks were deemed so risky that many depositors withdrew funds, so many that the banks were declared insolvent. This is the definition of a bank run, and is exactly what happened to Northern Rock in the UK in 2007.

Funny thing though, insolvent banks don't lend money because they don't exist. Therefore, the wave of bank runs and bank insolvencies that resulted from those runs reduced available credit in the system. Hence, irrespective of whatever liquidity the Federal Reserve supplied, the economy -- starved of credit - was destined to decline. And decline it did, with output falling 46% in nominal terms and unemployment peaking at 25%.

Mortgage lending

As one could imagine, getting a mortgage in those conditions was pretty difficult. Bank capital was husbanded tightly out of banks' logical fears of being the subject of the next bank run. Moreover, back then, there were strict interstate banking laws (laws that were only repealed in 1994.) So that meant that a lender was beholden to the local economy -- if an area hit the skids, so did its bank, reducing credit availability and further depressing the local economy.Enter Fannie Mae. Fannie Mae was created as a government agency to eliminate the restriction on mortgage credit availability - exactly the problem we are now experiencing.

Fannie Mae was founded as a government agency in 1938 as part of Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States.

In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, it was converted into a private corporation. Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae).

(Wikipedia)

In 1970, Freddie Mac was created, in order to further expand the government's role in creating a market for mortgage availability.

The FHLMC was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgages lending and increases the money available for new home purchases.

(Wikipedia)

Conclusion

One might believe for ideological purposes that the government should not be involved in the mortgage market because it distorts investment decisions. I have sympathy for that argument.

However, I also realize that it is times like these that necessitate government's participation in markets on some level. The US banking system as a whole is clearly undercapitalized and institutions are fearful of becoming the next Bear Stearns or Northern Rock. Therefore, liquidity has evaporated in the money markets and in the mortgage market. As a result, in the mortgage markets, before their conservatorship, Fannie and Freddie were responsible for 3/4 of mortgage lending in the US, up from 50% pre-crisis.

There is little the Federal Reserve could have done to correct this problem. The Fed has already done as much as it can -- I would argue more than is prudent -- to prevent another Depression-like scenario. It was high time, the US government stepped in to do something. Congress, as useless as ever, did not provide a solution. Therefore, it was up to the executive branch to show some leadership on this issue. And Hank Paulson stepped into the breach.

I do not like many features of his bailout plan because they do not eliminate the moral hazard that was complicit in creating the mess in the first place. His plan is also very political. It protects debt holders like China's central bank, which holds $400 billion in GSE debt. It protects foreign central banks generally, as they hold $1 1/2 trillion in GSE debt. It protects the likes of Bill Gross, who took a calculated risk in feasting on GSE debt, betting that such a plan was likely to happen. The plan does not wipe out equity capital, nor does it wipe out preferred equity holders entirely. These capital classes should bear all of the initial risk to future capital losses, not US taxpayers.

Moreover, there will be the sticky points of the government running and exiting from Fannie and Freddie. Will politics become an increasing factor in GSE decision-making? How will the GSE's attract top talent now that the profit motive is gone? How will the government extract itself from the GSEs: will it wind down Fannie and Freddie, hold on to them, or privatize them in part or in full? All of these questions need to be answered.

But Paulson's plan will be effective on many levels. It will certainly give the mortgage market a boost by lowering mortgage rates and increasing liquidity. This will have the net effect of putting a floor on house price declines in the US and eliminating one of the principal risks to the banking system. And I suspect that the US government will actually increase the GSE's lending in order to do exactly that. Of course, taxpayers will foot the bill on any lending losses.

So, there you have it. The mortgage problem in America has effectively been nationalized - socialized, if you will. Welcome to the United Socialist States of America. This is certainly not a desirable outcome for the bastion of capitalism that the USA believes itself to be.

But, is there any other solution? Personally, I think not? What do you think?

Related posts

• Solvency
• Fannie and Freddie: The politics of finance
• Freddie and Fannie taken over by US government
• Freddie and Fannie are getting nationalized
• Question: How is Fannie Mae a AAA company?
• Also see all previous posts under the label GSE.

Sources

• Unemployment Rate, US Bureau of Labor Statistics
• Federal Reserve Flow of Funds, Federal Reserve

Disclosure: I have no financial positions, equity, debt, or derivative in either Fannie Mae or Freddie Mac.

Comments

[SilverLeaf:]

Edward Harrison: Great work. While I don't agree with all your conclusions, I do applaud your research and tone. A few comments:

(1) Is there any other solution? That's a fair question. Like you, I choose to be critical, but respectfully so, of Hank Paulson and Congress. It is much easier to criticize them, than it is to propose a better plan, i.e. do a better job than they are.
(2) Contrary to what you indicated, shareholders were effectively wiped out. Theoretically, we were not. Ask any shareholder (me), and they would agree with me. I believe the 'moral hazard' problem would've been less imperfect if shareholders were diluted 50%, which is actually what Bill Ackman suggested. There was a precedent for something like this, in the Chrysler bailout, which ended up benefiting shareholders AND the government alike. Your comments on bondholders is dead on correct.
(3) Something that I've been itching to know (would appreciate it if you did know)...All articles about Fannie/Freddie conspicuously leave out their history in the 1980s and early 1990s...As I recall, Fannie was considered insolvent in the 1980s, and the stock price was well below $1.00..the government did not takeover, however. Fannie did recover, I'm not sure how, and you and I know where the stock price went (up).

2008 Sep 12 03:48 AM

[User 260928:]

First time posting here @ SA. I like your article. I wanted to point out that some people saw this coming 6 years ago. Here is an extract of an article entitled "In the Dream Business: U.S. Home Ownership" which was featured in the November 29, 2002 edition of Financial Times.

[quote]While critics abounded, the GSEs were credited with helping to boost home ownership levels from 64 percent to 68 percent over the last decade, while other segments of the economy faltered in 2002, the U.S. housing market continued to flourish. The lowest interest rates in three decades and the attractiveness of real estate for investment purposes also helped to keep the market strong.

Freddie Mac and Fannie Mae themselves benefited from the charged market, ranking among the most profitable companies in the United States. Their stunning success led to yet another wave of concern by some over their influence on the housing market. "They warn that a failure could drag down a U.S. Banking system highly dependent on Fannie- and Freddie-issued bonds and that taxpayers would be on the hook for a bail-out that would dwarf the savings and loans scandal of the 1980s," wrote Paul Taylor.[/quote]

I'm a bit of a conspiracy theorist and wonder if the Administration orchestrated this to dismantle Freddie and Fannie. The Republicans were the GSE's biggest critics -and- the Republicans also gained foothold of Congress in the '02 elections. After all, this is the Administration that blatantly lied to the American public about Weapons of Mass Destruction in Iraq, among other things. So Congress "failed" to come up with a solution for the 2 GSE's. The Treasury did the best that it could do, although I'm sure there is more that they could've done. I just hope that when the smoke clears and the dust settles, that the 2 GSE's return back to the hands of the Investors/Market and that they return in 1 piece.

I would also like to add that I vote for neither Democrat nor Republican. I vote for the person whom I think can do the best job. And I own shares of Freddie Mac, of which I am 'long' on.

2008 Sep 12 04:09 PM

[User 260928:]

Also, Silverleaf:
Here is a link to the entire company history of FNM (including the info I think you are looking for in your post). There is another one for FRE, as well, you just have to search it at the top. Very detailed history.

www.fundinguniverse.co...

2008 Sep 12 05:19 PM

[Edward Harr...:]

Silver Leaf and User 260928, I appreciate your kind words. When it comes to the financial meltdown, I am very conflicted. A close friend was let go at Bear after they were rescued. He also lost a shed load of money on the stock fall. Another friend just got the axe at Lehman. My mother-in-law was heavily invested in one of the regionals that is down 70 some percent and my sister just took a bath on Fannie and Freddie.

Long story, short: some people very close to me are affected. I see the human cost every day and its heart breaking. While we may talk about these things rationally and objectively, we must always remember that people's lives are at stake here.

That said, I have seen this train wreck coming for sometime. Others, even some close family members, have not understood the magnitude of the problem even though I have counseled them. I will continue to report on this as the story develops. My hope is that industry consolidation and bankruptcy will force a sharp and painful correction and then we can get on with business. My worry is that politics will rule the day and we will be in for a Japan-like scenario or worse.

Silver Leaf, as for seeing this way ahead of time, the problem in the 1980s and early 1990s were not as acute. Only in the last 10-15 years have FNM and FRE really spiraled out of control. Here is a list of Washington Post stories on the two dating back to 2005.

www.creditwritedowns.c...

Thanks again for your comments and feel free to visit my website or subscribe to my blog feed.

All the best.

Edward

2008 Sep 12 05:27 PM

[rogerk2:]

Great article. I have a couple of related thoughts.

1) FNM did just fine for 30 years, until the commercial bankers got their hands on it. Since then, it's been one scandal after another - exorbinant salaries, cooking the books, etc. Now the government has to take it back. We should have kept it as a government operation all along. It's as important to the fabric of American society as social security, medicare, and education. Oh yeah, they want to privatize those too, don't they!

2) Most great societies got that way because they were run by builders. Builders create jobs, make products, and pay salaries to poor people and well as rich people. Societies decline when they change to being run by lenders - people who profit from your misfortune, or from convincing you to live beyond your means. No individual, company, nation, or world can continue living beyond its means forever. It's just a matter of time.

Last century, we were the builders. This century, we got taken over by the financers. Rampant speculation in the 1920's led to the crash, and there wouldn't have been a run on the banks if they hadn't leveraged all their cash out to speculators. People felt, and rightly so, that when you put your money in a bank, it ought to be there for you...not in some risky venture designed to increase the bank's profits.

Today, the BRIC and some developing countries are the builders, and their government controls are keeping the lender-types at bay. Let's see how long that lasts.

2008 Sep 13 07:17 PM

[The Saint:]

Inevitably the US federal Reserve must act to prevent the closure of hundreds of 'corner store' banks and mortage companies having allowed them to unreasonably and irresponsibly lend to borrowers who a prudent banker would have known had not the slightest chance of repaying their loans in the event of an interest rate rise.

Falling asset (read: house) prices and interest rate rises produced the outcomes small borrowers, mainly in the mortgage belts, arefaced with today.

There is a fundamental defect in the thinking of most Americans who cannot see opportunities in the current market. Instead of running scared and running away from the problem, many who abandon their mortgages and homes with it, could well cluster together and create another pool from which they would be able to resurrect their failing fortunes and it is not rocket science.

If there is anyone out there interested in how it is done, we need to set up chapters in each suburb of each city. Because in the end there are also opportunities to secure government funding not to bail out a failed institution, but to support a thriving one with the capacity to inject new confidence into a sector of the economy that underpins the rest of the US economy.

2008 Sep 13 09:39 PM

[Adnrea:]

I think you're missing a key component here, another Depression Era bill - Glass-Steagall. The separation of banking and investing worlds brought about with that Act was demolished in 1999 with Gramm-Leach-Bliley, which I didn't like back when it was being discussed, didn't like when it passed, didn't like when Clinton signed it, and haven't liked as I've seen the banks and brokerages become intertwined over the last several years.

The bottom line is that anyone in government who says they didn't see this coming is flat lying. They needed this fake affluence from inflated home values to keep people spending and now it's come home to roost. The GSE's were between a rock and a hard place as their mandate was to increase home ownership, but there were points over the last several years where our public servants could have stepped in and didn't because it wouldn't have been all happy faces and warm fuzzies.

And now, LEH, MER & AIG? All mortgage related and probably too big to fail (B of A definitely will be soon). Socialism, indeed.

2008 Sep 15 01:32 PM