The Fred and Fan Folderol

I haven’t written much on Fannie Mae and Freddie Mac yet, because I’ve covered it and basically predicted it previously, and because I knew someone would put out a better column more quickly than I could.

First, here are excerpts from that better column, by Arnold Kling at Pajamas Media (bold is mine):

Fannie Mae and Freddie Mac are known as government-sponsored enterprises (GSEs) because they were created by the government and have enjoyed special regulatory privileges. However, they are both privately owned, with shares traded on the New York Stock Exchange.

Fannie Mae was created during the Depression, as an institution that would purchase mortgage loans. At the time, many regional banks failed, and Fannie Mae was like a giant national bank specializing in home mortgages.

Freddie Mac was created in 1970, to address a different problem. California was chronically short of mortgage money, and other states’ lending institutions had excess capital but were precluded by law from lending across state lines. Freddie Mac was chartered to create a “secondary mortgage market,” which would allow a mortgage lender in one state to purchase securities backed by mortgages originated by other lenders in other states. To do so, Freddie Mac guaranteed repayment of the loans.

Neither Freddie Mac nor Fannie Mae originates mortgage loans. As a home buyer, you will never deal directly with a GSE to obtain a loan. Instead, the GSEs buy mortgage loans that are originated by other firms, including banks and mortgage bankers.

….. Congress and regulators gave the GSEs a regulatory advantage in purchasing investment-quality loans, meaning loans to highly-qualified borrowers making substantial down payments (20 percent of the value of the home to avoid having to pay for mortgage insurance, or 10 percent of the value of the home if additional private mortgage insurance was obtained). Through regulatory differences, primarily in the form of capital requirements, banks were put at a disadvantage relative to the GSEs when it came to holding investment-quality loans.

However, the GSEs have recently suffered large credit losses on loans that were not of investment quality. These low-down-payment loans were similar to the subprime mortgage loans that fueled the boom and bust cycle in housing. It is not clear why the GSEs chose to purchase these loans, since they are outside of the GSE charters. One story has it that they were afraid of losing market share. Another story I have heard is that the GSEs were under pressure from Congress to do more to provide funds for “affordable housing,” and the GSEs interpreted this as requiring more high-risk lending.

Stop the tape, so to speak.

Fan and Fred looked to expand its mission, as government agencies or government-backed entities usually do. Because going to riskier, low down-payment loans was “outside of their charter,” I think it’s fair to ask if it was also illegal. In terms of why they did this, I choose the “affordable housing” pressures.

When real businesses go to far afield into areas they aren’t familiar with and fail, the market punishes the owners. This means that owners usually know better than to let their managers go too far outside their expertise. But when government agencies or government-backed entities do this, all too often, as is the case with Fan and Fred, there’s no penalty. Instead, there’s a bailout.

Back to Kling, who refers to a former member of the vice-presidential search committee of Democratic presidential candidate Barack Obama (link within excerpt is in original; bolds are mine) who has, like so many others, been thrown under the bus:

In hindsight, Freddie and Fannie were allowed to grow too large. They used political connections to fend off any attempt to rein them in, as can be seen in a 1997 story on James Johnson, then-chairman of Fannie.

The plan that Treasury Secretary Paulson announced on Sunday appears designed to shore up the GSEs and to return to the status quo prior to the recent loss of confidence by investors. In fact, however, I think it is unrealistic and undesirable to return to the status quo.

….. In my opinion, the playing field should be leveled as soon as possible so that banks can begin to buy assets from the GSE’s. Let the banks feed off the carcasses of Freddie and Fannie, just as Freddie and Fannie once fed off the carcasses of the S&Ls.

….. I see the GSE crisis as a failure of central planning. The GSEs were the victim of no one, unless you count the meddling by the Congressional meddlers whom the GSEs needed to please. Anyone could see that the GSE dominance of the mortgage market was unhealthy. But the political process was unable to get the job done. What the central planners tend to forget is that political failure is even more entrenched than market failure.

Many (although not all) of the GSEs’ enablers over the past decade have been Democrats.

….. The Treasury plan shows that the response to a failure of central planning is likely to be more central planning. Intellectually, those of us who prefer markets have a good case. Politically, we are in the process of getting steamrollered. The Treasury plan is being attached to a housing bill that was rife with corporate welfare and unsound subsidies. It ought to be vetoed, but instead it will be fast-tracked.

In other words, we’re, like, taken to the cleaners yet again.

If there’s anything to be learned from this going forward, it should be this: “No more bureacracies.” Not health care. Not energy crap and trade (not a typo). Not “industrial development.” Forget it. What government effort besides the military has ever worked as intended, or even if it has sort of worked, hasn’t cost exponentially more than intended?

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Now, here are selected previous posts on the Fan and Fred, with occasional selected quotes.

August 15, 2005 — Housing: Highly-Leveraged Borrowers Leave the Currently Strong Economy Vulnerable

Excerpt:

I’ve been saying for months that the overleveraged homeowner/consumer is the best reason not to break out the champagne about the currently and undeniably strong economy. The above makes it clear that though most of the (largely underreported) news has been good, the economy’s vulnerability to a cooling housing market or sharply higher overall interest rates remains very real.

October 11, 2005 — If There is Going to Be a Housing Bubble, It Could Largely Occur Because of Fan’s and Fred’s Trouble

Here’s a quote from the excerpted Wall Street Journal article about the accounting disasters at these companies, which should have been under the same strict SEC scrutiny that all other publicly-held entities must endure, but haven’t been:

In the past two years, accounting failures at Fannie Mae and Freddie Mac, known as Government Sponsored Enterprises (GSEs), have led to the largest financial restatements in history — totaling more than $20 billion — dwarfing the combined restatements of both Enron and WorldCom. In recent days, news reports indicate the financial misconduct could be wider and deeper than has emerged thus far.

The silence on these accounting messes out of Washington, with both parties accountable, was deafening for way too long.

Oct. 27, 2005 — Why Fan and Fred are SOOOO Screwed Up

Makes it clear that “community organizations,” meaning “Democratic Party activists who need a place to come to work everyday,” had alreadly been feeding at the trough for years, and were trying to get even more (I don’t know whether the legislation described at the link passed)

November 17, 2005 — Column of the Day: Fan and Fred Are “Scandals Waiting to Happen”

A now-timely observation and question from yours truly:

Note the Democrats’ chutzpah-laden “corporate coziness” charge. Despite the fact that the large majority of the portfolio buildup occurred in the 1990s while Democrats were in charge (including Democrat cronies in the executive suites), who do you think will get the Mainstream Media’s blame (partially but not fully deserved) if these GSEs blow up?

February 20, 2007 — The Credit Crunch That Sank the Economy?

I lined up the culpable. Also note that although Fan and Fred don’t and didn’t buy subprime loans, they did establish and lower the standards for them:

The Journal’s editorial is fine as far as it goes. But it forgot to mention the role the behemoths of loan securitization, namely government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, played in all of this:

• Those two GSEs lowered the credit scores and relaxing related documentation standards for “conventional” and sub-prime mortgages to the point where clearly unqualified borrowers were getting “conventional” treatment and borrowers who barely had a pulse credit-wise were getting sub-prime applications approved. A contact of mine in the lending industry told me in mid-2005 that the threshold for conventional approval was lowered from a credit score of about 670 to about 630, and for sub-primes dropped from about 630 to 590.
• Lenders aren’t blameless, because they “should” have been evaluating borrowers to prevent the most obvious train wrecks in-waiting from happening — independent of whether the relaxed “Fan and Fred” models said that these borrowers could afford the loans being offered. There’s precious little evidence that much of this happened.
• And, of course, borrowers themselves deserve a substantial share of the blame for not understanding what they were getting into.

March 7, 2007 – Is a Mortgage Melt-Down Around the Corner?

This presented a more complete list of the causes, and the causers:

Let’s see:

• Dangerous loan products.
• Government-sponsored enterprises (GSEs) like Freddie Mac and Fannie Mae lowering approval standards from about 2003-2006.
• Inflated appraisals, possibly widespread.
• Lenders who have closed deals when they often knew darned well that the borrowers were probably buying trouble.
• Ignorant, naive, too-trusting borrowers.
• Bankruptcy “reform” that could be forcing more borrowers into foreclosure before they fully realize what is happening to them.
• Now, a possible overreaction (perhaps egged on by Congress) in standard-tightening by the GSEs and lenders. Here’s some evidence from USA Today that this is indeed happening on the lender side, while this subscription-only item at March 12’s Biz Weak says that Freddie Mac and others “are finding religion by instituting tougher underwriting rules.”

Well, you can’t say the mortgage-lending industry hasn’t gone all-out in trying to screw the whole economy up. I still don’t think they will, but they certainly deserve a Devil’s “A” for effort.