FANNIE AND FREDDIE: THE ELEPHANTS IN THE ROOM
by Sarah Stranahan, New Economy Network and Ethical Markets Advisory Board
House Republicans recently introduced eight separate bills to limit and disempower the two big Government Service Enterprises (GSEs), Fannie Mae and Freddie Mac. Republicans in the House argue that failure to destroy the mortgage giants will “crowd out” private investment in the mortgage market.
“This will allow more private-market participation in the housing finance market, which is critical for the long-term health of the housing market and the overall economy,” said Representative Randy Neugebauer, a Texas Republican who is one of the eight party leaders who are each sponsoring one piece of the legislative package.”
This comes after the release in February of a report from HUD and the Treasury Department, “Reforming America’s Housing Finance”, which reached the same basic conclusion: Fannie and Freddie should be wound down in an orderly fashion and replaced by private markets.
“Under our plan, private markets – subject to strong oversight and standards for consumer and investor protection – will be the primary source of mortgage credit and bear the burden for losses.”
The difference between the administration and the Republicans boils down to a debate between death by stoning and death by starvation.
Fannie and Freddie are pretty attractive political targets. They are fundamentally flawed by design, hybrid public private enterprises that enjoyed “implicit” government guarantees. For several decades, they used this advantage to reap outsized profits and to invest in aggressive lobbying to protect their privileges. They were caught accounting scandals in the 1990s, and they have recently had a series of legal and management embarrassments. They were put into conservatorship by Hank Paulson in 2008, and have since cost the taxpayers more than $150 billion. Given all these flaws, “Kill the bastards” is an understandable response. It’s tempting to blame the sub-prime debacle on them, too.
But before we stone them to death, let’s remember, they are our bastards. The Treasury Department has authority over them, and we, the tax payers, own most of them. And they now support, through outright ownership or guarantees, 60% of the residential mortgage market. The FHA has the other 35%. The US housing market is in intensive care, and Freddie and Fannie are the IV lines keeping it (barely) alive. Before we pull the plug, let’s look at the facts.
Fannie and Freddie’s share of the mortgage market declined dramatically in 2004 through 2006, the peak years of the housing bubble. The bubble was fueled by private mortgage originators offering non-conforming loans (which are defined as not conforming to Fannie and Freddie’s loan standards), as the chart below shows. These were private Jumbo, Subprime and Alt-A loans. The development of structured products meant that for many consumers the free market offered a more attractive loan than the government subsidized one.
“The market shifted away from regulated GSEs and radically toward Mortgage Backed Securities (MBS) issued by unregulated private-label securitization conduits, typically operated by investment banks. Thus, the shift away from GSE securitization to private-label securitization (PLS) also corresponded with a shift in mortgage product type, from traditional, amortizing, fixed-rate mortgages (FRMs) to nontraditional, structurally riskier, non-amortizing, adjustable-rate mortgages (ARMs), and in the start of a sharp deterioration in mortgage underwriting standards.”
Now, take a look at what happens after the bubble pops. The private market exits stage left, and the only lenders left in the game were FHA and, you guessed it, our friends Fannie and Freddie.
So “private-market participation in the housing finance market” which, according to Representative Randy Neugebauer is “critical for the long-term health of the housing market and the overall economy” is kind of like teenagers who throw a party in your parents’ house and then run away when the cops come, leaving you to clean up the mess. Are these the people we want to trust with the future of our housing market?
If the sub-prime crisis was not Freddie and Fannie’s fault, then why do they still need a tax payer bailout? Are they mismanaged, incompetent or corrupt?
No, they simply have the misfortune of owning or guaranteeing half of the US housing market, which has continued to lose trillions of dollars of value since 2007. After the privateers took their profits and ran, Freddie and Fannie were left holding the Old Maid. Unlike Citi Bank, they couldn’t shut down their mortgage department and invest in Brazil; they have a public charter that requires them to invest in the US housing market.
Why do we think that private markets will do a better job next time? Is it because of our confidence in “strong oversight and standards for consumer and investor protection?” The banks are already chipping away at the Dodd Frank regulatory reforms, and Congress has defunded the SEC and the Consumer Financial Protection Bureau.
What if Fannie and Freddie, for all their flaws, are being framed? Before we lynch them, why not explore another option which is to use the power of federal conservatorship to manage them as public agencies to help staunch the foreclosure crisis, stabilize the housing market and recover jobs? We could use the power of conservatorship to refinance underwater homeowners at a fair fixed rate.
But wouldn’t a public agency be wasteful, or “crowd out” the private market? Actually, the public programs that have supported home ownership since the Depression have been largely successful. It was the “private” part of the hybrid structure that got Freddie and Fannie into trouble- the drive to compete with private banks for profit, share price and bonuses.
FDR created Fannie Mae in 1938 as a federal housing agency, and it was run as a public agency until 1968 when LBJ privatized it to help offset the cost of the Vietnam War. During the 30 years that Fannie Mae was run by the government, home ownership in American rose every decade, from 44% in 1940 to 55% in 1950 to 60% in 1960 and finally to 65% in 1990.
Well, maybe these government agencies increased home ownership and functioned well as wholly public agencies, but aren’t private markets better for the consumer, more efficient and less expensive? Not according to Ben Bernanke, describing the purely private pre-depression mortgage markets:
“Mortgage financing and typical lending terms (between 1890 and 1930) were far less attractive than those to which we are accustomed today. Required down payments, usually about half of the home’s purchase price, excluded many households from the market. Also, by comparison with today’s standards, the duration of mortgage loans was short, usually ten years or less. A “balloon” payment at the end of the loan often created problems for borrowers. High interest rates on loans reflected the illiquidity and the essentially unhedgeable interest rate risk and default risk associated with mortgages. Nationwide, the average spread between mortgage rates and high-grade corporate bond yields during the 1920s was about 200 basis points”.
It’s hard to get a mortgage now — imagine what would happen to the housing market if there were no GSEs to issue and insure mortgages? Mortgage rates will go up, 30 year mortgages will probably disappear (private lenders don’t want exposure to long term interest rate risk) which will make it difficult to buy a home, which will increase inventory and drive home prices down. But those low prices wouldn’t help most Americans who couldn’t get a mortgage. America could easily revert to a nation of renters, as we were before FDR created Fannie in 1938, when most Americans did not own a home.
Beyond this effect on the housing market, imagine what would have happened to the U.S. economy had Fannie and Freddie not been around to step in as lender of last resort and offset the collapse in the private mortgage market? There would have been even more severe declines in housing prices and greater losses for financial institutions. Freddie and Fannie have proven to be important sources of macro-economic stability during the last financial crisis.
But since we have bi-partisan agreement that their current hybrid design is dysfunctional, what other options do we have? Why not make them wholly public agencies like FHA and Ginnie Mae?
The Federal Housing Administration, which was created in 1934 to guarantee home mortgages, has been run as a public agency for 75 years. FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing. FHA provides a huge economic stimulation to the country in the form of home and community development, which trickles down to local communities in the form of jobs, building suppliers, tax bases, schools, and other forms of revenue.”
And how successful is Ginnie Mae, another wholly public agency? “For more than 40 years, Ginnie Mae has provided liquidity in times of crisis and ensured a stable secondary market for government insured loans. The reliance on Ginnie Mae during the current crisis only highlights this role. Ginnie Mae is well positioned to continue providing this support. Last year, this wholly-owned government corporation earned half a billion dollars; the previous year, it earned nearly a billion dollars” .
Better yet, we could convert Fannie and Freddie into foreclosure prevention agencies to help stabilize the housing market and keep Americans in their homes.
This is what TARP was supposed to do, and what Roosevelt did in the Great Depression. In 1933, five years before the creation of Fannie Mae, FDR created the Home Owners’ Loan Corporation.
“The Home Owners’ Loan Corporation was established during the summer of1933 to help families prevent the loss of their homes through mortgage foreclosure. The program provided for the exchange of HOLC bonds (with federal guarantee first of interest only but later, beginning in the spring of 1934, with guarantee of both interest and principal) for home mortgages in default and, in a few cases, for cash loans for payment of taxes and mortgage refinancing
“That’s right, the Federal government rescued homeowners in default by taking over their mortgage payments in exchange for HOLC bonds. It’s hard to imagine the government would ever assume responsibility for paying mortgages. Wasn’t this a breach of contract or a moral hazard or an invitation to default?
“By the autumn of 1934 over 400 HOLC offices were accepting applications. During the initial lending period—from June 1933 to June 1935—the HOLC received 1,886,491 applications for $6.2 billion of home mortgage refinancing, an average of $3,272 per application. According to estimates in the present study, HOLC refinancing was requested for about 40 percent of all mortgaged properties of qualifying size, value, and location, and for about one-fifth of the entire nation’s non-farm, owner-occupied dwellings. Nearly half the applications, however, were withdrawn or rejected. Roughly, one million refinancing loans totaling $3.1 billion and averaging $3,039 per loan were made, 70 percent of which were made during the twelve-month period beginning in March 1934. For the country as a whole, owners of about one out of ten nonfarm, owner-occupied dwellings (one- to four-family structures) and one out of five mortgaged dwellings received HOLC refinancing aid.”
Well then, wasn’t this a prohibitively costly program that drained the public coffers and racked up huge debts for future generations?
“Most observers and supporters originally expected the HOLC to lose money—perhaps a great deal. Yet by the spring of 1951, the HOLC had finally liquidated at a slight profit; borrowers had paid off their loan balances, for the most part, and the remaining balances were sold to private institutions.”
That’s right, during the depression, the Federal government intervened to help one out of ten homeowners reduce the interest and principle on their mortgages. Since government agencies already control 95% of the housing market, why aren’t we asking the government to do this again, instead of stoning the GSE to death in a collective purification ritual?
Actually, the idea of a new HOLC was advanced in 2008, and by no lesser luminaries than then NY Senator Hillary Rodham Clinton and economist Nouriel Roubini.
Senator Clinton published an op-ed in the Wall Street Journal on September 25, 2008, titled “Let’s Keep People in Their Homes”. For those of you too traumatized to remember the details, this was during the period Congress was debating the TARP bill while the markets were dropping by 500 points a day.
“This is not just a financial crisis; it’s an economic crisis. Therefore, the solutions we pursue cannot simply stabilize the markets. We must also deal with the interconnected economic challenges that set the stage for this crisis — and reverse the failed policies that allowed a potential crisis to become a real one.
“First, we must address the skyrocketing rates of mortgage defaults and foreclosures that have buffeted the economy and ignited the credit crisis. Two million homeowners carry mortgages worth more than their homes. They hold $3 trillion in mortgage debt. Nearly three million adjustable-rate mortgages are scheduled for a rate increase in the next two years. Another wave of foreclosures looms.
“I’ve proposed a new Home Owners’ Loan Corporation (HOLC), to launch a national effort to help homeowners refinance their mortgages. The original HOLC, launched in 1933, bought mortgages from failed banks and modified the terms so families could make affordable payments while keeping their homes. The original HOLC returned a profit to the Treasury and saved one million homes. We can save roughly three times that many today. We should also put in place a temporary moratorium on foreclosures and freeze rate hikes in adjustable-rate mortgages. We’ve got to stem the tide of failing mortgages and give the markets time to recover.”
Aside from her woefully over- optimistic assessment of the scale of the housing crisis, this is a sensible proposal from the then Senator from New York, who was soon to Secretary of State and never weighed in on domestic economic policy again.
What is Mr. Roubini case for a new HOLC?
“Households in the US have too much debt (subprime, near prime, prime mortgages, home equity loans, credit cards, auto loans and student loans) while their assets (values of their homes and stocks) are plunging, leading to a sharp fall in their net worth. The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe and the economic recession – with a sharp fall now in real consumption spending – now worsening. Rescuing distressed institutions without reducing the debt problem of the borrowers does not resolve the fundamental insolvency of the debtor that limits its ability to consume and spend and thus drags the economy into a more severe economic contraction.”
How did Mr. Roubini propose to reduce the debt problem of US households?
“During the Great Depression, the Home Owners’ Loan Corporation was create to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure.”
After TARP was passed, the public debate about Federal support of the housing market was limited to the effectiveness of HAMP (Home Affordable Modification Program), the future of Freddie and Fannie, the supervision and enforcement of mortgage standards, and the role and financing of the CFPB. There was little debate about more meaningful federal intervention in the housing market Economists first hoped that the rescued banks would begin lending again. They did not. Then they hoped that the first time home buyers tax credit would help the market rebound. It did briefly, but the markets collapsed again as soon as it ended. They finally hoped that the HAMP would staunch the continuing wave of foreclosures and stabilize the market. It never achieved any meaningful scale. It is now clear that that it may be years before the housing market recovers, and that falling home prices, underwater mortgages and foreclosures will continue to drag down American jobs and income.
Three years after the financial crisis, caused by irresponsible private sector speculation in the housing market, the US housing market is still a mess. Since the market collapse of 2007, prices have fallen more than 30% and are still falling; sales are down by more than 30% and are still falling; 25% of home owners owe more than their homes are worth; more than 6 million homes have been foreclosed and nine million more are in default; and total construction payroll employment has dropped by 2.1 million.
The sustained collapse of the housing sector has impacts far beyond the home prices: High mortgage costs erode disposable income, falling home prices destroy savings, weak markets trap homeowners in low employment areas, foreclosures hurt families and increase social service costs, and jobs in construction and related industries are lost.
A recent op-ed by Neil M. Barofsky, the special inspector general for the Troubled Asset Relief Program, reminds us that Congress authorized TARP to rescue the housing market as well as the banks, and that those promises are still broken:
“The bank bailout, more formally called the Troubled Asset Relief Program, failed to meet some of its most important goals.
“Though there is no question that the country benefited by avoiding a meltdown of the financial system, this cannot be the only yardstick by which TARP’s legacy is measured. The legislation that created TARP, the Emergency Economic Stabilization Act, had far broader goals, including protecting home values and preserving homeownership.
“These Main Street-oriented goals were not, as the Treasury Department is now suggesting, mere window dressing that needed only to be taken “into account.” Rather, they were a central part of the compromise with reluctant members of Congress to cast a vote that in many cases proved to be political suicide.
“The act’s emphasis on preserving homeownership was particularly vital to passage. Congress was told that TARP would be used to purchase up to $700 billion of mortgages, and, to obtain the necessary votes, Treasury promised that it would modify those mortgages to assist struggling homeowners. Indeed, the act expressly directs the department to do just that.
“But it has done little to abide by this legislative bargain. Almost immediately, as permitted by the broad language of the act, Treasury’s plan for TARP shifted from the purchase of mortgages to the infusion of hundreds of billions of dollars into the nation’s largest financial institutions.”
Now is the time to demand that the Treasury Department keep its promise to help homeowners, stabilize the housing markets, increase consumer spending and restore jobs. Instead of returning Fannie and Freddie to the private lenders who got us into this mess, let’s use our public assets in the public interest. Now is the time to demand that the existing public control over the GSEs and mortgage market be used to keep Americans in their homes, stabilize home values, lower mortgage costs and restore construction jobs. Let’s create a new HOLC and allow all qualified homeowners to refinance their homes.
i Binyam Appelbaum, In Congress, Bills to Speed Unwinding of 2 Giants. New York Times, March 29, 2011,
ii Department of the Treasury, US Department of Housing and Urban Authority, Reforming America’s Housing Finance Market, A Report to Congress
iii Housing Finance Agency, Conservator’s Report on the Enterprises’ Financial Performance Second Quarter 2010
iv Adam J. Levitin ,Explaining the Housing Bubble, Associate Professor of Law Georgetown University Law Center, and Susan M. Wachter, Richard B. Worley Professor of Financial Management University of Pennsylvania.
v US Census Bureau, Historical Census of Housing Tables Federal
vi Chairman Ben S. Bernanke. Housing, Housing Finance, and Monetary Policy Federal Reserve Bank of Kansas City’s Economic Symposium, Jackson Hole, Wyoming, August 31, 2007
vii HUD Website
viii Ginnie Mae website
viii C. Lowell Harris, History and Policies of the Home Owners’ Loan Corporation, 1951
xii Senator Hillary Clinton, Let’s Keep People In Their Homes, Wall Street Journal, September 26, 2008.
xiii Nouriel Roubini, We need a new HOLC – more than a new RTC or RFC- to provide massive debt relief to the household sector, Economonitor, September 19, 2008
xv Neil M. Barofsky, Where the Bailout Went Wrong, New York Times, March 29, 2011