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. Here, we'll examine the extent to which Fannie Mae, Freddie Mac, and their allies in Congress contributed to the largest financial crisis since the Great Depression.
- Fannie Mae was chartered by the U.S. Congress as a government-sponsored enterprise (GSE) in 1968, and Freddie Mac followed two years later.
- Fannie Mae and Freddie Mac were given a government-sponsored monopoly in a large part of the U.S. secondary mortgage market.
- This monopoly, combined with the government's implicit guarantee to keep these firms afloat, would later contribute to the mortgage market's collapse.
- In 2007, Fannie Mae and Freddie Mac began to experience large losses on their retained portfolios, especially on their Alt-A and subprime investments.
- 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.
Mortgage Markets: A Brief History
During the twentieth century, mortgage lending took place mostly at banks, savings and loans, thrifts, and credit unions. The most common type of mortgage was a fixed-rate mortgage. Most of the financial institutions originating mortgages held the mortgages that they originated on their books.
Fannie Mae was chartered by the U.S. Congress as a government-sponsored enterprise (GSE) in 1968, and Freddie Mac followed two years later. Fannie Mae was initially created in 1938 as part of the government, but things began to change quickly after its privatization in 1968. 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. They could sell mortgages on the secondary market shortly after origination. Selling mortgages freed up funds for creating additional mortgages.
Fannie Mae and Freddie Mac had a positive influence on the mortgage market by increasing homeownership rates in the United States. However, allowing Fannie Mae and Freddie Mac to function as implied government-backed monopolies had unintended consequences. History has shown that these consequences 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. As of September 6, 2008, they 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.
- The Secretary of the Treasury is authorized to purchase up to $2.25 billion of securities from each company to support their liquidity.
- 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. That includes implementing, enforcing, and monitoring their capital standards. FHFA also limits the size of their mortgage investment portfolios. HUD is responsible for the general housing missions of Fannie and Freddie.
Fannie and Freddie's GSE status created certain perceptions in the marketplace. The first of these was that the federal government would step in and bail out these organizations if either firm ever ran into financial trouble. This is 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 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 higher than U.S. Treasury bonds. AAA-rated financial firm debt has historically yielded about 70 basis points more than U.S. Treasury bonds. Thirty-five basis points do not seem like much, but it made a huge difference because of the trillions of dollars involved.
Private Profits With Public Risk
With a funding advantage over their Wall Street rivals, Fannie Mae and Freddie Mac made sizable profits for more than two decades. Over this time period, there was frequent debate about Fannie and Freddie among economists, financial market professionals, and government officials. Did the implied government backing of Fannie and Freddie actually benefit U.S. homeowners? Or was the government just helping the companies and their investors while creating moral hazard?
Fannie Mae and Freddie Mac were given a government-sponsored monopoly in a large part of the U.S. secondary mortgage market. This monopoly, combined with the government's implicit guarantee to keep these firms afloat, would later contribute to the mortgage market's collapse.
Fannie and Freddie's Growth
Fannie Mae and Freddie Mac grew very large in terms of assets and mortgage-backed securities (MBS) issued. With their funding advantage, they purchased and invested in huge numbers of mortgages and mortgage-backed securities. They made these investments with lower capital requirements than other regulated financial institutions and banks.
Figures 1 and 2 below show the incredible amount of debt issued by the companies, their massive credit guarantees, and the vast size of their retained portfolios of mortgage investments. U.S. Treasury debt is used as a benchmark.
Source: Office of Federal Housing Enterprise Oversight
Source: Office of Federal Housing Enterprise Oversight
Fannie Mae and Freddie Mac had many critics who raised red flags about the risks the companies were allowed to take. However, Fannie Mae and Freddie Mac found many allies in Congress despite these early warnings.
Competing firms and some government officials did call for tighter regulation of the mortgage giants. However, Fannie Mae and Freddie Mac hired legions of lobbyists and consultants. They also made campaign contributions through their own political action committees and funded nonprofit organizations to influence members of the U.S. Congress. They were allowed to continue to grow and take on risk under their congressional charters with implied federal backing.
Wall Street Rivals Join the Party
It should come as no surprise that competitors on Wall Street wanted in on the profit bonanza. They wanted to securitize and invest in the parts of the mortgage market that the federal government reserved for Fannie and Freddie. They found a way to do this through financial innovation, which was spurred on by historically low short-term interest rates.
Wall Street began to make a liquid and expanding market in mortgage products tied to short-term interest rates, such as LIBOR, starting in about 2000. These adjustable-rate mortgages were sold to borrowers as loans that the borrower would refinance out of long before payments adjusted upward. They frequently had exotic characteristics, such as interest-only or even negative-amortization features. Home loans were often made with lax underwriting guidelines, leading to the growth of subprime mortgages.
Investors such as pension funds, foreign governments, hedge funds, and insurance companies readily purchased the sophisticated securities Wall Street created from home mortgages. Fannie Mae and Freddie Mac saw their market shares drop. They then began to purchase and guarantee an increasing number of loans and securities with low credit quality.
The Party Ends
It is a simple fact that there is less risk of mortgage default when home prices are rising. The equity in a home is one of the best ways to measure the risk of default. Homeowners with large amounts of equity do not walk away from their mortgages because they have too much to lose. This is the model upon which homeowners, mortgage originators, Wall Street, credit rating agencies, and investors built the mortgage bonanza. Prices collapsed when the housing bubble burst, so many homeowners saw their equity wiped out. After losing their equity and their jobs, large numbers of homeowners were forced to default at the same time. Wall Street's sophisticated risk models did not include this scenario.
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. On March 19, federal regulators allowed the two firms to take on another $200 billion in debt in the hopes of stabilizing the economy. 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.
Congress Shares Some Blame
Many members of the U.S. Congress were strong supporters of Fannie Mae and Freddie Mac. Despite warnings and red flags raised by critics, they continued to allow the companies to increase in size. Fannie and Freddie were encouraged to purchase an increasing number of lower credit quality loans to help the disadvantaged and support the market. Wall Street would probably have introduced innovative mortgage products even in the absence of Fannie Mae and Freddie Mac. On the other hand, it might be concluded that Wall Street's expansion into exotic mortgages was motivated by the need to compete with Fannie and Freddie. Wall Street was looking for a way to cope with the implicit guarantee given to Fannie Mae and Freddie Mac by the U.S. Congress.
Fannie Mae and Freddie Mac created an enormous amount of debt and credit guarantees in the years leading up to 2007. Congress should have recognized the systematic risks to the global financial system that these firms posed. They should have considered the risks to U.S. taxpayers, who would eventually foot the bill for a government bailout.