When the housing bubble of 2001-2007 burst, it caused a mortgage security meltdown. This contributed to a general credit crisis, which evolved into a worldwide financial crisis. Many critics have held the United States Congress - and its unwillingness to rein in Fannie Mae and Freddie Mac - responsible for the credit crisis. In this article, we'll examine the extent to which Fannie Mae, Freddie Mac and their allies in Congress contributed to the largest financial and economic crisis since the Great Depression. (For background reading, see What Caused The Great Depression?)
A Brief History of Mortgage Markets
For most of the twentieth century, mortgage lending took place mostly at banks, thrifts, credit unions, and savings and loans. The most common type of mortgage was a fixed-rate mortgage and most of the financial institutions originating mortgages held the mortgages that they originated on their books.
Starting in 1968, when Fannie Mae was chartered by the U.S. Congress as a government-sponsored enterprise (GSE), and two years later when Freddie Mac was chartered as the same, things began to change quickly. (Fannie Mae was originally created in 1938, but until its privatization in 1968 it was a part of the U.S. government). Fannie Mae and Freddie Mac created a liquid secondary market for mortgages. This meant that financial institutions no longer had to hold onto the mortgages they originated, but could sell them into the secondary market shortly after origination. This in turn freed up their funds such that they could then make additional mortgages. (To learn more about secondary mortgages, see Behind The Scenes Of Your Mortgage.)
Fannie Mae and Freddie Mac had a positive influence on the mortgage market by increasing home ownership rates in the United States; however, as history has proved, allowing Fannie Mae and Freddie Mac to function as implied government-backed monopolies had major repercussions that far outweighed the benefits these organizations provided.
The Privileges of GSE Status
According to Fannie Mae and Freddie Mac's congressional charters, which gave them GSE status, they operated with certain ties to the United States federal government and, as of September 6, 2008, were placed under the direct supervision of the federal government.
According to their congressional charters:
- The president of the United States appoints five of the 18 members of the organizations' boards of directors.
- To support their liquidity, the secretary of the Treasury is authorized, but not required, to purchase up to $2.25 billion of securities from each company.
- Both companies are exempt from state and local taxes.
- Both companies are regulated by the Department of Housing and Urban Development (HUD) and the Federal Housing Finance Agency (FHFA). The FHFA regulates the financial safety and soundness of Fannie Mae and Freddie Mac, including implementing, enforcing and monitoring their capital standards, and limiting the size of their mortgage investment portfolios; HUD is responsible for Fannie and Freddie's general housing missions.
Fannie and Freddie's GSE status created certain perceptions in the marketplace, the first of which was that the federal government would step in and bail these organizations out if either firm ever ran into financial trouble. This was known as an "implicit guarantee".
The fact that the market believed in this implicit guarantee allowed Fannie Mae and Freddie Mac to borrow money in the bond market at lower rates (yields) than other financial institutions. The yields on Fannie Mae and Freddie Mac's corporate debt, known as agency debt, was historically about 35 basis points (.35%) higher than U.S. Treasury bonds, while 'AAA-rated' financial firms' debt was historically about 70 basis points (.7%) higher than U.S. Treasury bonds. A 35-basis-point difference might not seem like a lot, but on borrowings measured in trillions of dollars, it adds up to huge sums of money. (For more on agency debt see, Agency Bonds: Limited Risk And Higher Return.)
Private Profits With Public Risk
With a funding advantage over their Wall Street rivals, Fannie Mae and Freddie Mac made large profits for more than two decades. Over this time period, there was frequent debate and analysis among financial and housing market professionals, government officials, members of Congress and the executive branch about whether Fannie and Freddie's implied government backing was working mostly to benefit the companies, their management and their investors, or U.S. homeowners (particularly low-income homeowners) as was part of these firms' HUD-administered housing mission.
One thing was clear: Fannie Mae and Freddie Mac were given a government-sponsored monopoly on a large part of the U.S. secondary mortgage market. It is this monopoly, combined with the government's implicit guarantee to keep these firms afloat, that would later contribute to the mortgage market's collapse. (For more on the secondary mortgage market, see Behind the Scenes of Your Mortgage.)
Fannie and Freddie's Growth
Fannie Mae and Freddie Mac grew very large in terms of assets and mortgage-backed securities (MBSs) issued. With their funding advantage, they purchased and invested in huge numbers of mortgages and mortgage-backed securities, and they did so with lower capital requirements than other regulated financial institutions and banks.
Figures 1 and 2, below, produced by the companies' former regulator, the Office of Housing Enterprise Oversight, show the incredible amount of debt issued by the companies, their massive credit guarantees, and the huge size of their retained portfolios (mortgage investment portfolios). U.S. Treasury debt is used as a benchmark.
|Source: Office of Federal Housing Enterprise Oversight|
|Source: Office of Federal Housing Enterprise Oversight|
A Cause for Concern
Fannie Mae and Freddie Mac had many critics who tried to raise a red flag of concern about the risks the companies were allowed to take thanks to their implicit government backing. However, despite these early warning cries, Fannie Mae and Freddie Mac found many allies in Congress.
While Fannie Mae and Freddie Mac's rivals, along with some public authorities, called for tighter regulation of the mortgage giants, the companies hired legions of lobbyists and consultants, made campaign contributions through their own political action committees, and funded nonprofit organizations to influence members of the U.S. Congress to ensure that they were allowed to continue to grow and take on risk under their congressional charters and implied federal backing.
The GSE's Wall Street Rivals Join the Party
It should come as no surprise that Fannie and Freddie's rivals on Wall Street wanted in on the profit bonanza of securitizing and investing in the portion of the mortgage market that the federal government had reserved for Fannie Mae and Freddie Mac. They found a way to do this through financial innovation, which was spurred on by historically low short-term interest rates. (To learn more, read What is securitization?)
Starting in about 2000, Wall Street began to make a liquid and expanding market in mortgage products tied to short-term interest rates such one-year CMT, MTA, LIBOR, COFI, COSI and CODI. These adjustable-rate mortgages were sold to borrowers as loans that the borrower would refinance out of long before the rate and/or payment adjusted upward. They frequently had "exotic" characteristics such as interest-only or even negative-amortization features. In addition, they were frequently made with lax underwriting guidelines such as stated income and/or stated assets. Subprime lending took off. (For more insight, see Subprime Lending: Helping Hand Or Underhanded?)
Investors such as pension funds, foreign governments, hedge funds and insurance companies readily purchased the sophisticated securities Wall Street created out of all the mortgages it was now purchasing. As Fannie Mae and Freddie Mac saw their market shares drop, they too began purchasing and guaranteeing an increasing number of loans and securities with low credit quality.
The Party Ends When Home Prices Stagnate and Fall
It's a simple fact that when home prices are rising, there is less risk of mortgage default. The equity in a home is the single biggest risk measure of default. Homeowners with large amounts of equity do not walk away from their mortgages, and can usually refinance out of a mortgage with soon-to-be-expected payment increases into another mortgage with low initial payments. This is the model upon which homeowners, mortgage originators, Wall Street, credit rating agencies and investors built the mortgage bonanza. When the housing bubble burst, so did all of their sophisticated risk models. (To learn more, read How Will The Subprime Mess Impact You?)
In 2007, Fannie Mae and Freddie Mac began to experience large losses on their retained portfolios, especially on their Alt-A and subprime investments. In 2008, the sheer size of their retained portfolios and mortgage guarantees led the FHFA to conclude that they would soon be insolvent. By September 6, 2008, it was clear that the market believed the firms were in financial trouble, and the FHFA put the companies into "conservatorship". American taxpayers were left on the hook for future losses beyond the companies' existing - and shrinking - capital cushions.
Conclusion: The U.S. Congress is Largely to Blame
Members of the U.S. Congress were strong supporters of Fannie Mae and Freddie Mac. Despite warnings and red flags raised by some, they continued to allow the companies to increase in size and risk, and encouraged them to purchase an increasing number of lower credit quality loans. While it is probable that Wall Street would have introduced innovative mortgage products even in the absence of Fannie Mae and Freddie Mac, it might be concluded that Wall Street's expansion into "exotic" mortgages took place in part in order to compete and take market share from Fannie Mae and Freddie Mac. In other words, Wall Street was looking for a way to compete with the implicit guarantee given to Fannie Mae and Freddie Mac by the U.S. Congress.
Meanwhile, Fannie Mae and Freddie Mac's debt and credit guarantees grew so large that Congress should have recognized the systematic risks to the global financial system these firms posed, and the risks to U.S. taxpayers, who would eventually foot the bill for a government bailout.