Fannie and Freddie Fleece the Taxpayers
August 18, 2008
William F. Shughart II
Readers of a certain age might remember the old newspaper cartoon of a man so down on his luck that he resorts to wearing an empty barrel held in place by suspenders. If Fannie Mae and Freddie Mac continue on their present course, barrels may again become fashionable for US taxpayers.
Criticized last week as “fatally flawed” by Alan Greenspan, the two so-called mortgage giants are at the center of the current financial crisis. Owned by private investors but chartered by Congress for the purpose of supplying liquidity to mortgage lenders, thereby putting home ownership within the reach of more Americans, Fannie and Freddie aggressively participated in the booming housing market of the early 21st century. By the end of the third quarter of 2007, the two were guaranteeing—or had purchased outright—roughly half of the nation’s home mortgages, accumulating in the process $5.2 trillion worth of debt, nearly $4 trillion more than on their books in 2003.
The roof then fell in. Real estate prices plummeted, mortgage default rates soared, and the market value of Fannie and Freddie’s asset portfolios—primarily consisting of the income expected from the mortgages they owned and the mortgage-backed securities they sold to investors—went into freefall. Crisis might have been averted had the two companies kept reserves adequate for meeting such a contingency, but Fannie and Freddie’s regulator, the Department of Housing and Urban Development’s Office of Federal Housing Oversight, demanded reserves of just 3 percent, a figure much lower than required of banks and other financial institutions and one that in hindsight was utterly irresponsible.
Last month, as Fannie and Freddie’s losses mounted and concerns grew that their collapse might cause meltdowns in financial markets both at home and abroad, Congress enacted rescue legislation. Among other provisions, July’s housing-relief bill allows the Treasury to extend unlimited lines of credit to Fannie and Freddie and, if necessary, to buy their stock. Undercutting the common perception that the housing crisis was precipitated by “predatory” lending to low-income, subprime borrowers who did not qualify for conventional loans, the new law also authorizes Fannie and Freddie to buy mortgages worth up to $625,000.
In a worst-case scenario, the two companies would be taken over by the federal government. Taxpayers would then be fully responsible for their combined $5.2 trillion in debt, instantly increasing the national debt by 50 percent.
One might have thought that the federal government’s recent actions represented a necessary response to financial events beyond Fannie and Freddie’s control. But that would be wrong. Ahead of the real estate bust a year ago, they were as eager to purchase or to guarantee risky home loans as banks and other institutions were to make them. “Alt-A” mortgages, home loans in a category somewhere between prime and subprime, now account for 10 percent of the single-family mortgages on Freddie Mac’s books and 11 percent of those on Fannie Mae’s. For good reason, such mortgages, negotiated with borrowers who cannot or will not fully document their income or assets, have been called “liar loans”. Indeed, it is only because lenders believed (evidently correctly) that they could shift their risk to Freddie and Fannie that they were willing to make such loans in the first place.
Fannie and Freddie’s reckless practices were in turn encouraged by the belief (again evidently justified) that they had grown too big to be allowed to fail. Fannie Mae lost $2.3 billion in the second quarter of 2008; Freddie lost $821 million during the same period. For the year ending last June 30, the two companies posted losses totaling $14 billion. As of June 30, the estimated market value of the assets on Freddie Mac’s books was a negative $5.6 billion. Relying in part on last month’s housing bill allowing the Federal Housing Authority to make some $300 billion available for refinancing existing home mortgages, Fannie and Freddie say they will attempt to raise additional capital privately and to take steps to slow loan defaults and home foreclosures.
But in an environment where it is now clear that the two companies are backed by the full faith and credit of the US government, the potential liabilities of taxpayers will continue to balloon. Although Fannie claims to have tightened requirements for liar loans, it will keep buying them until year’s end. Stay tuned for more bad news.