Summary:
It was jarring for me to go through the HAMP process to get principal reduction for my mortgage approved, having personally experienced the after effects of 2008 financial crisis. In the end, all I was able to do was a change in the type of the loan from Adjustable Rate Mortgage (ARM) to 30 Year Fixed rate Mortgage. The same set of documents I was more than ready to provide with my original loan application(which was not requested at that time by the mortgage originator to determine my creditworthiness) became massively important when I applied for mortgage modification. Ever since that experience, I have always wondered how housing mortgages work in the US. This book is an attempt at explaining Fannie Mae and Freddie Mac, the 2 companies that serve US mortgage market. It is written by Bethany McLean, whose earlier book on Enron is as close to engrossing fiction a nonfiction book can get. In the space of 10 years (after 2008), people have moved on from the housing craze to an atmosphere of doom and gloom in spite of US economy's solid fundamentals. It is also a book about how good intentions (of expanding home ownership to all levels of American society) can quickly go awry in the hands of financiers and politicians. In the aftermath of Financial crisis, Tea Party movement exploded onto the scene (after Rick Santelli's famous rant) rejecting the massive role government played in propping up homeowners whose house values were underwater(that banks got a bigger bailout than the homeowners was ignored, which considering Tea Party's primary financial backers (Koch brothers), should not have been a surprise). Tea Party movement made it toxic for legislators to address the problem of underwater mortgages through principal reduction at a time of increasing job losses, even though they gave a pass to the multiple bailouts of banks. Because Fannie Mae and Freddie Mac were guaranteeing individual mortgages, they came under withering fire from the Tea Party movement as well. The repeated attacks on Fannie Mae and Freddie Mac is a massive climb down from 1990's when both of these companies had politicians in their pockets and routinely beat back attempts by Republicans and Democrats to regulate them. They used their position as the guarantors of US residential mortgages as a cudgel and were quite successful at it. Because they were neither exclusively government agencies or private sector companies at the time of financial crisis, they did not have any supporters when their position became dicey after the 2008 financial crisis. Fannie Mae and Freddie Mac are an emblem of the bankruptcy of the idea of American Dream as it is currently promoted (Home ownership). Home owners in US get a significant say in their communities (as compared to renters whose lack of property tax obligations also reduces their contribution to the economic decisions in their communities). That is also the reason why the practice of redlining was extensive as a method of denying minorities a shot at home ownership.
Analysis:
Across the globe, countries usually opt for socialized health care (free or subsidized) and free markets in housing.US is an exception in that it has free market in healthcare (Obamacare's attempts at "socialized medicine" notwithstanding) and socialism in its housing market. The general practice across the globe is to have bank deposits or bonds issued against pools of mortgages to cover the cost of mortgages for banks. This has the effect of making short term ARM the default mortgage across the globe whereas the most common mortgage in US is 30 Year Fixed Rate Mortgage. Mortgages usually have 3 types of risks - Credit risk (risk that the homeowner will not pay), Interest rate risk (risk that a rise in interest rate will reduce the earnings on a mortgage than they would have otherwise earned from an equivalent financial instrument) and Prepayment risk (risk that the homeowner will prepay the mortgage which will force the lender to look for another comparable asset). Lenders are comfortable with interest rate and prepayment risks whereas they stay away from credit risk. By assuring lenders that they will face minimal credit risk when they start lending to people for house purchases, Fannie Mae and Freddie Mac encourage the lenders to provide long term 30 Year Fixed rate mortgages. They are also referred to as Government sponsored enterprises (GSEs). As a result, they took on significant amount of debt (by assuring the lenders that if homeowners failed to pay up, Fannie Mae and Freddie Mac would make the lenders whole). During the 2008 financial crisis, Fannie and Freddie were identified as part of the problem that led to the meltdown of US housing market. The losses sustained by both the companies resulted in them being put under "conservatorship" which meant the Treasury department provided the companies a line of credit and in return, both companies came under the control of a government agency. Republicans despise Freddie Mac and Fannie Mae for being the symbols of government intrusion into what they consider should be free market in housing. Democrats hate these companies for not doing enough to satisfy the mission for which they were created - expand home ownership across all income levels in America. Because home ownership is invariably tied to American dream, these GSEs got in the middle of heated discussions about American Dream's meaning and pursuit during the financial crisis even though they were only too happy to take credit for expanding home ownership in the period before the financial crisis.
In the aftermath of Great Depression, US President Franklin Delano Roosevelt (FDR) envisioned home ownership as a way to provide the broader American public, a stake in the broader economic growth of America. Till 1930's, while home ownership remained a cherished goal for Americans, the financial infrastructure for low income and middle class people to achieve those goals were not in place. In 1920's, unscrupulous businessmen took advantage of the lack of housing regulations to swindle people off their hard earned money. With support from Herbert Hoover (who was the US President before FDR), Congress passed Federal Home Loan Bank Act in 1932 that allowed US government to support regional banks to lend to homeowners through their local branches. In 1933, FDR pushed Congress to pass Federal Housing Act which created Federal Housing Administration (FHA). The act also put in place procedures to insure lenders against defaults on long term fixed rate mortgages with low down payments. This led to uniformly low interest rates for mortgages across the US - there were racial disparities in access to these loans which suppressed home ownership among minority populations(redlining). Private lenders were expected to set up mortgage associations that would buy these long term mortgages from the lenders. However, no private lender stepped up (which was understandable as there was no benefit for the lender per se other than the public good of ensuring access to low interest rate mortgages). As a proof of concept to encourage lenders, FHA set up Federal National Mortgage Association (FNMA or Fannie Mae). Till 1967, Fannie Mae was a government entity. During President Lyndon Johnson's administration, a budgetary commission recommended that the debt of Fannie Mae be included in the federal deficit. US government did not want massive amount of Fannie Mae's debt influence the federal deficit. As a result, US government agreed to split Fannie Mae into 2 parts - a government agency called Government National Mortgage Association (Ginnie Mae) that guaranteed credit on FHA and Veterans Administration mortgages and Fannie Mae which was allowed to remake itself as a public company, focused on credit risk on mortgages for the rest of the American population. To encourage investors to buy Fannie Mae's stock, US government assured them that Fannie Mae had the backing of US Treasury and that Federal banks (part of the Federal Reserve system) could buy unlimited amounts of Fannie Mae's debt. This led to investors assuming (correctly) that Fannie Mae stock was similar to US Treasury. US government preferred to consider Fannie Mae as a publicly owned company (even though the value of the stock was driven primarily by the financial backing of the US government). With the growth of Fannie Mae as a large player in the mortgage market, Congress established Federal Home Loan Mortgage Corporation (Freddie Mac) as a competitor. For all practical purposes, Fannie Mae and Freddie Mac were indistinguishable and served as twin pillars of the booming US housing market.
In 1980's, Wall Street came up with a new product called mortgage securitization. Wall Street firms would buy up pools of mortgages from lenders, package them and sell them to investors. Originally it was envisioned as a way of supplanting the GSEs from the mortgage market by having investors share the credit risk on mortgages. In reality, Investors balked at buying mortgages from private lenders without the imprimatur of Fannie Mae or Freddie Mac. Congress even nudged the lenders by passing legislation allowing private label securities to be issued but it had no effect. By 1990's the realization that they were the only game in town in mortgage guarantees emboldened Fannie Mae and Freddie Mac to build up political muscle through their lobbying operation. That political power allowed them to beat back repeated efforts from private sector banks to rein them in. Private sector banks used their clout in Congress to set up a government agency, Office of Federal Housing Enterprise Oversight (OFHEO). Fannie Mae and Freddie Mac successfully weakened the agency oversight process by capping the budget of OFHEO at around $20 million which was less than what the top 4 executives at Fannie Mae and Freddie Mac took home as average salary annually ($33 million). Private sector banks did succeed in forcing Fannie Mae and Freddie Mac to hold capital reserves (in case of any crisis) but even in this case, the lobbying operation of Fannie Mae and Freddie Mac succeeded in capping the capital reserve at a very low level(compared to the overall size of their financial portfolio). The GSEs successfully lobbied for this cap by arguing that home mortgages were inherently less risky than loans lent out by the private banks. They also agreed to meet affordable housing goals by issuing a certain percentage of their overall loan volume to borrowers below national median income or those who lived in rural areas. Their acceptance of affordable housing goals came back to bite them in the aftermath of the financial crisis, when Republicans latched on to those goals as the reason why risky borrowers ended up getting mortgages and causing the housing meltdown. The rush to judgment among Republicans in blaming the affordable housing goals as the cause of the financial crisis ignores reality (which is par for the course for Republican Party given its tenuous connection to fact based approaches) - Fannie Mae and Freddie Mac were legally required to have mortgage insurance (PMI) on loans that were more than 80% loan to value ratio, Subprime lending was pioneered by private lenders in 1990's and it took almost 10 years for the GSEs to start guaranteeing those types of loans. Since these loans stayed on the balance sheet of the GSEs and could not be offloaded (unlike private banks who used increasingly sophisticated (or delusional) products like SPVs to offload their loans to other banks thereby propagating the risk across the financial system). The growth of US housing market was reflected in the size of the mortgage market that Fannie Mae and Freddie Mac handled - it grew from $3.1 trillion in 1990 to $5.5 trillion in 2000.
The size and centrality of Fannie Mae and Freddie Mac meant they were able to insinuate themselves into every corner of the US financial system. To finance their operations, they raised huge amounts of debt which provided Wall Street firms with a steady stream of revenue through fees. Because they were considered to be the second most stable financial instrument (after US Treasury bonds), they were also used as collateral in the growing derivatives market. Foreign investors (governments and individuals) used similar logic to hold onto the GSE backed mortgage securities. By 2004, Foreign governments and individuals owned around $875 billion in mortgage securities. The boom times for US economy in general and housing in particular hid the nature of the financial alchemy that US had achieved - a illiquid investment (that cannot be readily converted to cash) of 30 Year Fixed rate fully prepayable mortgage (with credit, prepayment and interest rate risks) was turned into the second most liquid security (after the US Treasury bonds). With the housing market continuing to boom, Freddie Mac and Fannie Mae branched out from guaranteeing mortgages (for a fee) into holding some of the mortgage backed securities that Wall Street developed, on their balance sheet. This would come back to haunt them during the financial crisis when everyone realized how badly Wall Street had whiffed in evaluating the credit worthiness of these securities so a mortgage security built out of risky mortgages ended up getting a AAA (the highest possible value) rating from the credit rating agencies. The perception was that the GSEs privatized their gains (which went to the top executives and share holders) and socialized their losses (US government had guaranteed their existence, after all). By 1999, the GSEs announced they would start buying mortgage securities that had subprime mortgages in them - these were mortgages that had high interest rates and were usually handed out to people with less than stellar credit. Politicians on both sides of the aisle, helped the growth of Fannie Mae and Freddie Mac (after all, the tie-in of home ownership to American Dream meant only a politician intent on career suicide would oppose Fannie Mae and Freddie Mac as they were perceived to be spreading the wealth of home ownership across all income levels in America). Bill Clinton's administration rolled out the National Home Ownership Strategy whereas George W Bush rolled out the Ownership society. The lobbying power of GSEs also made them a lot of political enemies.
Their downfall started with Freddie Mac getting cited for accounting fraud in 2003. Arthur Andersen was its auditor and that firm's involvement in Enron scandal had triggered investigations into other companies that had used Arthur Andersen's auditing services. Freddie Mac hired PriceWaterhouse Coopers as its new auditor and was forced to restate its earnings by almost $5 billion. The episode also showed how toothless OFHEO, the government agency regulating GSEs was. OFHEO had signed off on the GSEs' financial health months before the accounting scandal erupted. Sensing an opportunity, George W Bush administration worked in concert with Federal Reserve under Alan Greenspan to curtail the power of the GSEs. After further investigations, OFHEO determined that the income restatement should be $11 billion and not $5 billion as originally thought. This led to the ouster of the top management of the GSEs leading to severe reputation hit for those companies. Because there was no political will to replace them with a better alternative, GSEs continued to plod on, performing their responsibilities with low capital reserves and generally loading up on risky mortgages (which, at that time, was done by private lenders as well). When the housing crash started in 2008, Fannie Mae and Freddie Mac started posting multi billion dollar losses on a monthly basis. The heavy footprint of foreign investors (governments (primarily, China and Japan) and individuals) meant that US government had no choice but to step in with a financial lifeline for the GSEs. The alternative would have been serious doubts on the credibility of the promises of US government leading to a run on the dollar. Between 2008 and 2014, US Federal Reserve (under Ben Bernanke) would purchase $2.8 trillion worth of mortgage backed securities.
The anger that homeowners expressed at seeing their houses underwater while big banks got bailouts forced US government to come up with programs (for example, HAMP) to mitigate the worst effects of the crisis. Even among homeowners, there were bitter divisions between people who requested principal reductions in their mortgages (so they could get a lower monthly payment without losing equity in their homes) versus people who thought that principal reduction would bail out irresponsible homeowners(the moral hazard concern). Owing to fierce criticism, Fannie Mae and Freddie Mac shrunk back to their original mission, that of providing guarantees for mortgages for a fee. To accommodate the extensive availability of riskier mortgages, the GSEs increased fees for those types of mortgages instead of turning them down. Repeated attempts by Democrats and Republicans to get rid of Fannie Mae and Freddie Mac foundered on the shoals of actual reality - without addressing the necessity of home ownership for achieving American dream, reform measures had no effect on the GSEs as the question always came back to the nature of their replacement. At the end of George W Bush administration, both the GSEs were placed into Conservatorship - their management teams were fired, political lobbying on their behalf was terminated and US government bought 79.9% stake in them. Buying 100% stake in the GSEs would have nationalized them but it would have also put their debt on US government's federal deficit with its attendant effect on the dollar. US government assured holders of Fannie Mae and Freddie Mac debt and mortgage backed securities that US government stood behind them. But the US government cut off preferred and common stock (equity) holders. This contrasted with the bank bailouts where both debt and equity holders were given government guarantees and banks' management teams left in place. Just before the US government stepped in, a group of hedge fund investors saw an opportunity in the crashing
stock prices of the GSEs and loaded up on their junior preferred stocks. Their expectation was that the government would put the GSEs into conservatorship and restore them to financial health and then re-make them into public companies again at which point the hedge fund investors would make a killing. They had done rigorous analysis which showed that losses in Fannie Mae and Freddie Mac were overblown. On the other hand, US government and the Treasury wanted to take advantage of the financial crisis to cut the GSEs down to size. To that end, US Treasury announced in August 2012 that, moving forward, GSEs would send all their earnings to US Treasury as opposed to the 10 % dividend they had been sending to Treasury prior to the crisis. When US Treasury announced this decision, the common and preferred stocks of GSEs crashed in value. This led to the hedge fund investors suing US government for expropriating private property (common and preferred stock) and violating the terms of the conservatorship agreement with GSEs. US Treasury argued that hedge fund investors were ignoring the perilous position of the GSEs and accused them of profiting off government's conservatorship efforts. By this time, US Treasury had come to rely on GSEs earnings to reduce the federal deficit as well.
Currently, GSEs are still under government conservatorship because Republicans and Democrats cannot agree on a path forward. Free market conservatives, emboldened under Donald Trump, are trying their utmost to get rid of GSEs completely in the (pie in the sky) hope that private agencies will step in to provide the same service (ignoring repeated historical lessons that private sector has not done that on an equitable basis). Moderate Republicans and Democrats do not want to get caught defending GSEs (especially after the pounding GSEs took after 2008 crisis) while recognizing their value in promoting home ownership. As a result, they are paralyzed in laying out a future path for GSEs. Because the GSEs were set up with the explicit goal of advancing home ownership (and consequently, American Dream), any permanent resolution to the current situation of GSEs can only be achieved by addressing the implausibility of American Dream. Since politicians would much rather garner votes selling a dream than none at all, an enduring solution to American homeownership is politically impossible in the current context.
It was jarring for me to go through the HAMP process to get principal reduction for my mortgage approved, having personally experienced the after effects of 2008 financial crisis. In the end, all I was able to do was a change in the type of the loan from Adjustable Rate Mortgage (ARM) to 30 Year Fixed rate Mortgage. The same set of documents I was more than ready to provide with my original loan application(which was not requested at that time by the mortgage originator to determine my creditworthiness) became massively important when I applied for mortgage modification. Ever since that experience, I have always wondered how housing mortgages work in the US. This book is an attempt at explaining Fannie Mae and Freddie Mac, the 2 companies that serve US mortgage market. It is written by Bethany McLean, whose earlier book on Enron is as close to engrossing fiction a nonfiction book can get. In the space of 10 years (after 2008), people have moved on from the housing craze to an atmosphere of doom and gloom in spite of US economy's solid fundamentals. It is also a book about how good intentions (of expanding home ownership to all levels of American society) can quickly go awry in the hands of financiers and politicians. In the aftermath of Financial crisis, Tea Party movement exploded onto the scene (after Rick Santelli's famous rant) rejecting the massive role government played in propping up homeowners whose house values were underwater(that banks got a bigger bailout than the homeowners was ignored, which considering Tea Party's primary financial backers (Koch brothers), should not have been a surprise). Tea Party movement made it toxic for legislators to address the problem of underwater mortgages through principal reduction at a time of increasing job losses, even though they gave a pass to the multiple bailouts of banks. Because Fannie Mae and Freddie Mac were guaranteeing individual mortgages, they came under withering fire from the Tea Party movement as well. The repeated attacks on Fannie Mae and Freddie Mac is a massive climb down from 1990's when both of these companies had politicians in their pockets and routinely beat back attempts by Republicans and Democrats to regulate them. They used their position as the guarantors of US residential mortgages as a cudgel and were quite successful at it. Because they were neither exclusively government agencies or private sector companies at the time of financial crisis, they did not have any supporters when their position became dicey after the 2008 financial crisis. Fannie Mae and Freddie Mac are an emblem of the bankruptcy of the idea of American Dream as it is currently promoted (Home ownership). Home owners in US get a significant say in their communities (as compared to renters whose lack of property tax obligations also reduces their contribution to the economic decisions in their communities). That is also the reason why the practice of redlining was extensive as a method of denying minorities a shot at home ownership.
Analysis:
Across the globe, countries usually opt for socialized health care (free or subsidized) and free markets in housing.US is an exception in that it has free market in healthcare (Obamacare's attempts at "socialized medicine" notwithstanding) and socialism in its housing market. The general practice across the globe is to have bank deposits or bonds issued against pools of mortgages to cover the cost of mortgages for banks. This has the effect of making short term ARM the default mortgage across the globe whereas the most common mortgage in US is 30 Year Fixed Rate Mortgage. Mortgages usually have 3 types of risks - Credit risk (risk that the homeowner will not pay), Interest rate risk (risk that a rise in interest rate will reduce the earnings on a mortgage than they would have otherwise earned from an equivalent financial instrument) and Prepayment risk (risk that the homeowner will prepay the mortgage which will force the lender to look for another comparable asset). Lenders are comfortable with interest rate and prepayment risks whereas they stay away from credit risk. By assuring lenders that they will face minimal credit risk when they start lending to people for house purchases, Fannie Mae and Freddie Mac encourage the lenders to provide long term 30 Year Fixed rate mortgages. They are also referred to as Government sponsored enterprises (GSEs). As a result, they took on significant amount of debt (by assuring the lenders that if homeowners failed to pay up, Fannie Mae and Freddie Mac would make the lenders whole). During the 2008 financial crisis, Fannie and Freddie were identified as part of the problem that led to the meltdown of US housing market. The losses sustained by both the companies resulted in them being put under "conservatorship" which meant the Treasury department provided the companies a line of credit and in return, both companies came under the control of a government agency. Republicans despise Freddie Mac and Fannie Mae for being the symbols of government intrusion into what they consider should be free market in housing. Democrats hate these companies for not doing enough to satisfy the mission for which they were created - expand home ownership across all income levels in America. Because home ownership is invariably tied to American dream, these GSEs got in the middle of heated discussions about American Dream's meaning and pursuit during the financial crisis even though they were only too happy to take credit for expanding home ownership in the period before the financial crisis.
In the aftermath of Great Depression, US President Franklin Delano Roosevelt (FDR) envisioned home ownership as a way to provide the broader American public, a stake in the broader economic growth of America. Till 1930's, while home ownership remained a cherished goal for Americans, the financial infrastructure for low income and middle class people to achieve those goals were not in place. In 1920's, unscrupulous businessmen took advantage of the lack of housing regulations to swindle people off their hard earned money. With support from Herbert Hoover (who was the US President before FDR), Congress passed Federal Home Loan Bank Act in 1932 that allowed US government to support regional banks to lend to homeowners through their local branches. In 1933, FDR pushed Congress to pass Federal Housing Act which created Federal Housing Administration (FHA). The act also put in place procedures to insure lenders against defaults on long term fixed rate mortgages with low down payments. This led to uniformly low interest rates for mortgages across the US - there were racial disparities in access to these loans which suppressed home ownership among minority populations(redlining). Private lenders were expected to set up mortgage associations that would buy these long term mortgages from the lenders. However, no private lender stepped up (which was understandable as there was no benefit for the lender per se other than the public good of ensuring access to low interest rate mortgages). As a proof of concept to encourage lenders, FHA set up Federal National Mortgage Association (FNMA or Fannie Mae). Till 1967, Fannie Mae was a government entity. During President Lyndon Johnson's administration, a budgetary commission recommended that the debt of Fannie Mae be included in the federal deficit. US government did not want massive amount of Fannie Mae's debt influence the federal deficit. As a result, US government agreed to split Fannie Mae into 2 parts - a government agency called Government National Mortgage Association (Ginnie Mae) that guaranteed credit on FHA and Veterans Administration mortgages and Fannie Mae which was allowed to remake itself as a public company, focused on credit risk on mortgages for the rest of the American population. To encourage investors to buy Fannie Mae's stock, US government assured them that Fannie Mae had the backing of US Treasury and that Federal banks (part of the Federal Reserve system) could buy unlimited amounts of Fannie Mae's debt. This led to investors assuming (correctly) that Fannie Mae stock was similar to US Treasury. US government preferred to consider Fannie Mae as a publicly owned company (even though the value of the stock was driven primarily by the financial backing of the US government). With the growth of Fannie Mae as a large player in the mortgage market, Congress established Federal Home Loan Mortgage Corporation (Freddie Mac) as a competitor. For all practical purposes, Fannie Mae and Freddie Mac were indistinguishable and served as twin pillars of the booming US housing market.
In 1980's, Wall Street came up with a new product called mortgage securitization. Wall Street firms would buy up pools of mortgages from lenders, package them and sell them to investors. Originally it was envisioned as a way of supplanting the GSEs from the mortgage market by having investors share the credit risk on mortgages. In reality, Investors balked at buying mortgages from private lenders without the imprimatur of Fannie Mae or Freddie Mac. Congress even nudged the lenders by passing legislation allowing private label securities to be issued but it had no effect. By 1990's the realization that they were the only game in town in mortgage guarantees emboldened Fannie Mae and Freddie Mac to build up political muscle through their lobbying operation. That political power allowed them to beat back repeated efforts from private sector banks to rein them in. Private sector banks used their clout in Congress to set up a government agency, Office of Federal Housing Enterprise Oversight (OFHEO). Fannie Mae and Freddie Mac successfully weakened the agency oversight process by capping the budget of OFHEO at around $20 million which was less than what the top 4 executives at Fannie Mae and Freddie Mac took home as average salary annually ($33 million). Private sector banks did succeed in forcing Fannie Mae and Freddie Mac to hold capital reserves (in case of any crisis) but even in this case, the lobbying operation of Fannie Mae and Freddie Mac succeeded in capping the capital reserve at a very low level(compared to the overall size of their financial portfolio). The GSEs successfully lobbied for this cap by arguing that home mortgages were inherently less risky than loans lent out by the private banks. They also agreed to meet affordable housing goals by issuing a certain percentage of their overall loan volume to borrowers below national median income or those who lived in rural areas. Their acceptance of affordable housing goals came back to bite them in the aftermath of the financial crisis, when Republicans latched on to those goals as the reason why risky borrowers ended up getting mortgages and causing the housing meltdown. The rush to judgment among Republicans in blaming the affordable housing goals as the cause of the financial crisis ignores reality (which is par for the course for Republican Party given its tenuous connection to fact based approaches) - Fannie Mae and Freddie Mac were legally required to have mortgage insurance (PMI) on loans that were more than 80% loan to value ratio, Subprime lending was pioneered by private lenders in 1990's and it took almost 10 years for the GSEs to start guaranteeing those types of loans. Since these loans stayed on the balance sheet of the GSEs and could not be offloaded (unlike private banks who used increasingly sophisticated (or delusional) products like SPVs to offload their loans to other banks thereby propagating the risk across the financial system). The growth of US housing market was reflected in the size of the mortgage market that Fannie Mae and Freddie Mac handled - it grew from $3.1 trillion in 1990 to $5.5 trillion in 2000.
The size and centrality of Fannie Mae and Freddie Mac meant they were able to insinuate themselves into every corner of the US financial system. To finance their operations, they raised huge amounts of debt which provided Wall Street firms with a steady stream of revenue through fees. Because they were considered to be the second most stable financial instrument (after US Treasury bonds), they were also used as collateral in the growing derivatives market. Foreign investors (governments and individuals) used similar logic to hold onto the GSE backed mortgage securities. By 2004, Foreign governments and individuals owned around $875 billion in mortgage securities. The boom times for US economy in general and housing in particular hid the nature of the financial alchemy that US had achieved - a illiquid investment (that cannot be readily converted to cash) of 30 Year Fixed rate fully prepayable mortgage (with credit, prepayment and interest rate risks) was turned into the second most liquid security (after the US Treasury bonds). With the housing market continuing to boom, Freddie Mac and Fannie Mae branched out from guaranteeing mortgages (for a fee) into holding some of the mortgage backed securities that Wall Street developed, on their balance sheet. This would come back to haunt them during the financial crisis when everyone realized how badly Wall Street had whiffed in evaluating the credit worthiness of these securities so a mortgage security built out of risky mortgages ended up getting a AAA (the highest possible value) rating from the credit rating agencies. The perception was that the GSEs privatized their gains (which went to the top executives and share holders) and socialized their losses (US government had guaranteed their existence, after all). By 1999, the GSEs announced they would start buying mortgage securities that had subprime mortgages in them - these were mortgages that had high interest rates and were usually handed out to people with less than stellar credit. Politicians on both sides of the aisle, helped the growth of Fannie Mae and Freddie Mac (after all, the tie-in of home ownership to American Dream meant only a politician intent on career suicide would oppose Fannie Mae and Freddie Mac as they were perceived to be spreading the wealth of home ownership across all income levels in America). Bill Clinton's administration rolled out the National Home Ownership Strategy whereas George W Bush rolled out the Ownership society. The lobbying power of GSEs also made them a lot of political enemies.
Their downfall started with Freddie Mac getting cited for accounting fraud in 2003. Arthur Andersen was its auditor and that firm's involvement in Enron scandal had triggered investigations into other companies that had used Arthur Andersen's auditing services. Freddie Mac hired PriceWaterhouse Coopers as its new auditor and was forced to restate its earnings by almost $5 billion. The episode also showed how toothless OFHEO, the government agency regulating GSEs was. OFHEO had signed off on the GSEs' financial health months before the accounting scandal erupted. Sensing an opportunity, George W Bush administration worked in concert with Federal Reserve under Alan Greenspan to curtail the power of the GSEs. After further investigations, OFHEO determined that the income restatement should be $11 billion and not $5 billion as originally thought. This led to the ouster of the top management of the GSEs leading to severe reputation hit for those companies. Because there was no political will to replace them with a better alternative, GSEs continued to plod on, performing their responsibilities with low capital reserves and generally loading up on risky mortgages (which, at that time, was done by private lenders as well). When the housing crash started in 2008, Fannie Mae and Freddie Mac started posting multi billion dollar losses on a monthly basis. The heavy footprint of foreign investors (governments (primarily, China and Japan) and individuals) meant that US government had no choice but to step in with a financial lifeline for the GSEs. The alternative would have been serious doubts on the credibility of the promises of US government leading to a run on the dollar. Between 2008 and 2014, US Federal Reserve (under Ben Bernanke) would purchase $2.8 trillion worth of mortgage backed securities.
The anger that homeowners expressed at seeing their houses underwater while big banks got bailouts forced US government to come up with programs (for example, HAMP) to mitigate the worst effects of the crisis. Even among homeowners, there were bitter divisions between people who requested principal reductions in their mortgages (so they could get a lower monthly payment without losing equity in their homes) versus people who thought that principal reduction would bail out irresponsible homeowners(the moral hazard concern). Owing to fierce criticism, Fannie Mae and Freddie Mac shrunk back to their original mission, that of providing guarantees for mortgages for a fee. To accommodate the extensive availability of riskier mortgages, the GSEs increased fees for those types of mortgages instead of turning them down. Repeated attempts by Democrats and Republicans to get rid of Fannie Mae and Freddie Mac foundered on the shoals of actual reality - without addressing the necessity of home ownership for achieving American dream, reform measures had no effect on the GSEs as the question always came back to the nature of their replacement. At the end of George W Bush administration, both the GSEs were placed into Conservatorship - their management teams were fired, political lobbying on their behalf was terminated and US government bought 79.9% stake in them. Buying 100% stake in the GSEs would have nationalized them but it would have also put their debt on US government's federal deficit with its attendant effect on the dollar. US government assured holders of Fannie Mae and Freddie Mac debt and mortgage backed securities that US government stood behind them. But the US government cut off preferred and common stock (equity) holders. This contrasted with the bank bailouts where both debt and equity holders were given government guarantees and banks' management teams left in place. Just before the US government stepped in, a group of hedge fund investors saw an opportunity in the crashing
stock prices of the GSEs and loaded up on their junior preferred stocks. Their expectation was that the government would put the GSEs into conservatorship and restore them to financial health and then re-make them into public companies again at which point the hedge fund investors would make a killing. They had done rigorous analysis which showed that losses in Fannie Mae and Freddie Mac were overblown. On the other hand, US government and the Treasury wanted to take advantage of the financial crisis to cut the GSEs down to size. To that end, US Treasury announced in August 2012 that, moving forward, GSEs would send all their earnings to US Treasury as opposed to the 10 % dividend they had been sending to Treasury prior to the crisis. When US Treasury announced this decision, the common and preferred stocks of GSEs crashed in value. This led to the hedge fund investors suing US government for expropriating private property (common and preferred stock) and violating the terms of the conservatorship agreement with GSEs. US Treasury argued that hedge fund investors were ignoring the perilous position of the GSEs and accused them of profiting off government's conservatorship efforts. By this time, US Treasury had come to rely on GSEs earnings to reduce the federal deficit as well.
Currently, GSEs are still under government conservatorship because Republicans and Democrats cannot agree on a path forward. Free market conservatives, emboldened under Donald Trump, are trying their utmost to get rid of GSEs completely in the (pie in the sky) hope that private agencies will step in to provide the same service (ignoring repeated historical lessons that private sector has not done that on an equitable basis). Moderate Republicans and Democrats do not want to get caught defending GSEs (especially after the pounding GSEs took after 2008 crisis) while recognizing their value in promoting home ownership. As a result, they are paralyzed in laying out a future path for GSEs. Because the GSEs were set up with the explicit goal of advancing home ownership (and consequently, American Dream), any permanent resolution to the current situation of GSEs can only be achieved by addressing the implausibility of American Dream. Since politicians would much rather garner votes selling a dream than none at all, an enduring solution to American homeownership is politically impossible in the current context.
No comments:
Post a Comment