"Fannie and Freddie - From Privatization to Nationalization in Forty-Two Years?"

Sydney M. Williams

Thought of the Day

“Fannie and Freddie – From Privatization to Nationalization in Forty-Two Years?”

June 22, 2010

Last Wednesday, Edward DeMarco, acting director of the Federal Housing Finance Agency (responsible for both Fannie Mae and Freddie Mac), stated: “A voluntary delisting at this time simply makes sense and fits the goal of a conservatorship to preserve and conserve assets.” While a delisting does not mean there will no longer be public shareholders, it has meant that their shares are worth less – about half of what they were valued on Tuesday.

In a sense, Fannie Mae (Federal National Mortgage Association) is reverting to its origin. The company was established in 1938, as part of the New Deal. Like today, the collapse of the housing market during the Depression discouraged private lenders from offering home loans. Fannie Mae was set up to provide local banks with federal funds to finance home mortgages – known as conforming mortgages. As the secondary market developed for these mortgages, Fannie Mae grew, borrowing at low rates (with U.S. Government guarantees) and lending at a rate high enough to earn a reasonable ‘spread’.

The system worked well. Home ownership increased. Mortgages were simple affairs, usually twenty to thirty years in duration. Down payments were generally 20% of the value of the house and mortgages were typically no more than three times the borrowers’ annual income.

As home ownership rose during those post-War years, so did the balance sheet of Fannie Mae. In 1968, President Lyndon Johnson, encumbered domestically with the war on poverty and internationally with the war in Vietnam, chose to privatize Fannie Mae, so as to remove the Company’s debt from a ballooning Federal deficit. Two years later Freddie Mac (Federal Home Mortgage Association) was created to provide competition for Fannie Mae.

Though privatized, both GSEs (Government Sponsored Enterprises) enjoyed the continued benefits of exemption from state and local taxes, exemption from oversight by the SEC and their bonds traded with an “implicit” guarantee from the U.S. Government – permitting them to borrow at lower rates than private competition.

A combination of developments took place. In 1977, the Community Reinvestment Act was passed and signed into law by President Carter (and strengthened by the Gramm-Leach-Bliley Act of 1999). It essentially encouraged (required) FDIC compliant banking institutions to meet the needs of all segments of their communities, including low-and moderate-income neighborhoods. Secondly, declining interest rates from about 1982 forward had the beneficial affect of raising asset prices. Third, technology introduced complexity into mortgage offerings – adjustable rates, balloons, interest-only mortgages and myriad others. Significant, but selective political donations provided a cover from Congress. So, despite being public and without SEC supervision, the potential for extraordinary riches proved too tempting for managements, as the tale of former Fannie Mae CEO Franklin Raines relates.

In 2006, when a $10.6 billion accounting scandal broke – manipulating financial reports to allow earnings that would trigger bonuses for senior executives – an attempt at reform by the Bush Administration was blocked by Democrats who claimed that the real victims would be low-income borrowers made unable to buy homes. Reform failed.

When the credit crisis boiled over in the fall of 2008, Fannie Mae and Freddie Mac were placed, almost immediately, in conservatorship and the government became an 80% owner of the equity.

In last Sunday’s New York Times, Binyamin Applebaum reported that thus far, “the tab [for the two GSEs] stands at $145.9 billion and it grows with every foreclosure…The Congressional Budget Office predicts the final bill could reach $389 billion.” The bill may be substantially higher. The two companies, with a combined market capitalizations of $750 million, have total debt of just under $5 trillion, offset by mortgages held. (To put that $4.8 trillion in context, total residential mortgages in the U.S. are about $10 trillion.) The question, without a known answer, is what is the value of the underlying mortgages? Given the number of foreclosures over the past couple of years and the fact that a number of mortgages exceed the collateral value of the houses mortgaged – perhaps 25% of all mortgaged properties, according to some estimates – it is fair to assume the two GSEs are technically bankrupt.

Mr. Applebaum, in his Times article, also makes the point that the two companies owned 163,828 homes at the end of March, and that, in foreclosure sales, on average the company’s recoup less than 60% of the money the borrower failed to repay. While 164,000 homes is a large number, it should be placed in the context that there are, according to U.S. Census data, 105 million households in the U.S. and that existing home sales are running around 5 to 6 million a year. (Existing home sales are due out today and are expected to be around 6.15 million.)

Despite all the noise, though, most homeowners continue to pay their mortgages, hoping, over time, to build equity. Nevertheless, the government is between a rock and a hard place – they cannot allow the two entities to fail and, given the size of the Federal debt - $13.1 trillion – they do not want to take on another $5 trillion in debt, so a re-nationalization seems unlikely at this time. Given the fraud and the corruption that permeated these two entities and the unhealthy ties they had to the Congress of the United States where millions of tax payer dollars went into the coffers of Senators like Chris Dodd and Chuck Schumer, it is hard to believe that both Fannie Mae and Freddie Mac appear to have been left out of the financial reform bill. But perhaps that too-cozy relationship and recognition that the problems are too monumental provided an exemption? Regardless, Congress should, once the crisis has ebbed, revisit its relationship and prevent such an occurrence from happening in the future.