Fed Takeover of Freddie and Fannie May Provide Temporary Stability, But Is it Just a Band-Aid?

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By now, most have heard the news that the Federal Government stepped in on Sunday to exercise the authority granted to it by Congress in July to bail out government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. The major features of the move include the ouster of the two companies’ chief executive officers, the acquisition by the Treasury of $1 billion of the companies’ preferred stock and a pledge of up to $200 billion more, and the placing of the companies in conservatorship (a type of federally-managed bankruptcy) with management control placed into the hands of the Federal Housing Finance Agency.

This report in the Silicon Valley Business Journal discusses the potential impact of the takeover on interest rates and taxpayer dollars. Government officials, such as those quoted in this fascinating MSN article, have hailed the move as providing necessary stability to a volatile market and keeping mortgages affordable. Others are questioning whether this will be enough to balance out the markets, especially given the cost (see Seattle Times article here).

Though few can argue that the stability of the mortgage markets is a worthy goal, I find the takeover troubling for a variety of reasons. Fannie Mae was created as a government agency in the late 1930s expressly to provide liquidity to the mortgage market. It was later converted into a private corporation in 1970, at the same time that Freddie Mac was created to provide competition to Fannie’s monopoly, to establish a secondary market to purchase mortgages and repackage them as securities. Since then, these organizations have existed as quasi-governmental entities in the murky ether between public and private. This uncertainty about what exactly these organizations are and who they represent has often led to an increase rather than a decrease in volatility in the mortgage markets.

This has been especially true in recent months as speculation about Freddie and Fannie’s fate swirled around Wall Street. If these are governmental agencies, then they should be supported by the full faith and credit of the United States Government. If they are private corporations, then they should fail. Instead, we have seen them handled with hesitancy, and with a bailout that many say has come too late.

But the status of these organizations is really a secondary question to the one that nobody seems to want to address – is the stated purpose of Freddie and Fannie a goal the U.S. Government, or anyone for that matter, should promote? Namely, do we really want to artificially inject liquidity into the mortgage market? This entire subprime crisis, and the broader credit crisis it has spawned, can be fairly attributed to an excess of liquidity in the mortgage market. This and the process of securitization, by which each player in the chain (borrower to broker to lender to investment bank to investor) could pass on the risk of a mortgage to the next, created a market in which anyone who could fog a mirror could get a loan. Was this a good thing? Nobody cared if a given borrower could really repay a loan because the secondary market’s appetite for these loans was voracious. Did this ultimately result in either a stable or a liquid market?

This takeover is therefore all the more troubling because it seems only to prop up the misguided policy at the heart of this crisis. Returning to the stated goals of government officials, it’s clear that injecting liquidity into the mortgage market was again one of the foremost drivers behind this move. But, nobody stopped to ask whether keeping mortgages affordable for all who want them is a good thing. Maybe borrowers who cannot afford nice homes should settle for more modest homes or (gasp) rent until they can afford them. What a novel concept!

It seems to me that the goal should be a mortgage market that accurately reflects the value of real estate and the available financing, not one that treats home ownership as a Constitutional right.

This entry was posted in broader credit crisis, causes of the crisis, education, Fannie Mae, Freddie Mac, legislation, lenders, liquidity, mortgage market, securitization, stability, subprime, takeover. Bookmark the permalink.
  • http://DavieGnoreply@blogger.com Davie G

    >I generally agree with this posting by blogger extraordinaire, Isaac Gradman, however, I have a few points I’d like to add. First of all, I think that a liquid mortgage market is a good thing and helps banks remain flexible if they need to reposition and makes ownership of real estate more affordable. However, I agree that the Public-Private nature of Fannie and Freddie has basically led to complete havoc in today’s financial world because they were allowed to remain in existence after the private sector fulfilled their public purpose. Fannie and Freddie’s debt and equity were highly rated in large part because of the market’s perception that they were backed by the full faith and credit of the US government and too big to fail. This perception was widely held amongst those in the financial world which in many ways tied the hands of the current administration to intervene. My question is, who is at fault for creating this too big to fail perception? Is it Fannie and Freddie for whispering this in the ear of credit rating agencies or whoever gave them quasi-public status to begin with, or is it the credit agencies themselves? I imagine any public-private partnership needs to have strict rules at the inception from the public side that say, hey Mr. Private Co, if you start to squander away the business, the public is pulling the plug on you and will have someone else handle things. The fact that so many competitors entered the secondary mortgage market forced Fannie/Freddie to lower their standards to stay competitive. To make matters worse, the securities these competitors were selling were rated as if they TOO were backed by the full faith and credit of the US government. The problem really probably lies in the conflict of interest inherent in the GSE’s. They owed their shareholders the obligation of growing earnings, but they owed the government the obligation of not getting into risky loans. If they were truly government entities, and the government had control, the treasury department could have said, hey there are plenty of other companies providing the needed liquity to the secondary mortgage market, so let’s force Fannie and Freddie to pack their bags and go home before lending standards go down. But the government didn’t control them, the shareholders did! Which meant the inmates were running the asylum and lending standards went out the window. But, because they still had this quasi public status (without any real government oversight), the GSE’s got into subprime market and still held onto those AAA ratings. Also at fault are the rating agencies for treating Fannie/Freddie’s private competitors as if they too were backed by the government. And now, our government is bailing everyone out and basically rewarding everyone who sold junk to the uninformed public. I hope that Fannie and Freddie are chopped up and re-privatized and there are NO MORE BAIL OUTS OF PRIVATE COMPANIES so that the next wave of dealers of secondary mortgage is responsible for their actions. It wouldn’t hurt if these credit agencies had a brain and some critical independent thought before giving every mortgage backed security a AAA rating next time as well. The problem isn’t liquidity in the mortgage market, the problem is the public involvement without oversight and inaccurate ratings of securitized loan portfolios.