Culprits In The Economic Meltdown Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac, officially known as “government sponsored enterprises” or GSEs were at the center of the collapse What do they do? Do they offer loans to home buyers? No, they instead buy loans from banks on the secondary market. After a bank offers a home loan to a customer, it then sells the loan to Fannie or Freddie. So the loan is no longer on the originating bank’s books, because Fannie and Freddie are now responsible for it, receiving the income stream of monthly payments and bearing the risk if the homeowner should default. Fannie and Freddie may hold the mortgages in their own portfolios, but they often bundle them into mortgage-backed securities for sale to investors.

In the meantime, the banks that originally offered the loans, having gotten rid of the risks by selling the mortgages to Fannie or Freddie now have the funds to extend to new borrowers. This whole process spurs more mortgage lending than would have otherwise taken place, making it easier for people to buy homes. However, this fake diversion of resources into mortgage lending inflates home prices. The special privileges granted to Fannie and Freddie create an artificial reality and are certainly not an example of a free market.

Fannie Mae, created in the 1930s and “privatized” in 1968, and Freddie Mac, created in 1970, receive special tax and regulatory privileges that their potential competitors do not. Their stock, traded on the New York Stock Exchange and designated as “government securities,” can be held by banks as low risk bonds. Fannie had for years a special $2.25 billion line of credit with the U.S. Treasury.

This is the free market?

Investors and lenders took for granted that if Fannie needed it, this line of credit would be essentially unlimited. Of course if the GSEs got into trouble they would be bailed out by the taxpayers.

What a great business model! Over extend to maximize profits, and yet risk nothing, because the innocent will pay the price.

Good job Government!

This advantage allowed Fannie and Freddie to raise more money from investors and make higher offers for mortgages than their competitors could. By 2008, they had a hand in about half the country’s mortgages, and almost three-quarters of the new mortgages.

Government intervention at its best!

Fannie Mae and the political establishment, in the name of helping the “disadvantaged,” worked to lower lending requirements. As the New York Times reported in 1999, Fannie Mae’s initiative would encourage banks to “extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” The Clinton Administration pressured Fannie Mae “to expand mortgage loans to low and moderate income people.” The program only extended mortgages to all potential borrowers who could qualify, but one of the programs goals was to “increase the number of minority and low-income home owners who [tended] to have worse credit ratings than non-Hispanic whites.” Surprisingly, the Times, known for its deep understanding of economics, understood the risk: “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic down-turn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

Congressional Republicans, seeing the danger, called for more regulation and oversight on the two GSEs, as Fannie and Freddie continued to increase their riskier obligations, but the Democrats balked, accusing the Republicans of attacking “affordable housing.” The cynics, or those more astute in politics, thought that there might be a different reason the Democrats didn’t want additional scrutiny on Fannie Mae: it was run by prominent Democrats and was a significant campaign donor to the DNC.

Ka-ching!

Congressional Democrats decided to leave their party’s piggy bank alone. Franklin Raines, “earned” $100 million after a brief stay there, and oh by the way, was Clinton’s budget director.

Government at its honest best.

If they didn’t allow the market to set rates on a rational non-politicized basis, then at least some oversight would have been helpful, especially if the public was ultimately on the hook to cover any losses. Private companies would have had to bear the full responsibility and brunt of any losses but not the GSEs.

Does anyone every wonder where the government gets its money? Certainly not Congress!

According to the New York Times, Democrats feared that “tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.” Barney Frank declared that Fannie and Freddie were “not facing any kind of financial crisis… The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” Ron Paul, on the other hand, warned before the House Financial Services Committee on 10 September 2003 of Fannie and Freddie’s destructive consequences would have for the U.S. economy:

The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore the holders of the mortgage debt will also have a loss. These losses will be greater then they would have otherwise been had government policy not actively encouraged over investment in housing.

Despite warnings such as Ron Paul’s, the Democratic leadership protected Fannie Mae from oversight and the Republican leadership did nothing.

Barney Frank and the Democrats are still in charge, the Republicans are taking credit for their new found fiscal restraint, and Ron Paul still doesn’t get any credit.

Inspired by Meltdown by Thomas E. Woods. Jr.