Until recently it was possible to regard the US system of housing finance as one of the best – if not the best – in the world. Just as it was intended to, it has supported very high levels of home ownership, notably among the less prosperous. But the semi-public entities chiefly responsible for that success, and the financial technologies they devised and promoted, are deeply implicated in the housing market crash that now threatens the US and world economies. Will that turmoil lead to a scaling back of their role? Most likely no. They are cast as part of the solution. Their already dominant role in housing finance is set to grow still further.
Fannie Mae was established by Congress in 1938. At the end of the 1960s it was restructured and, in 1970, joined by Freddie Mac. Their role is to provide “liquidity and stability in the secondary mortgage market”, with an emphasis on supporting housing loans to the less well-off. They buy mortgages from originating lenders and either hold these directly on their books or else securitise them and sell them on with a guarantee to other investors. Freddie Mac devised the first conventional mortgage-backed security.
Few Americans have any idea what Fannie and Freddie actually do – but they certainly do a lot of it. According to their supervising agency, the Office of Federal Housing Enterprise Oversight (Ofheo), at the end of the third quarter they had $3,200bn of mortgage-backed securities outstanding and held another $1,400bn of mortgages and securities on their own books. Together, the two institutions accounted for fully 40 per cent of US mortgage debt outstanding.
The exact nature of these colossal undertakings is ambiguous. Formally, despite their congressional charters and official designation as “government sponsored enterprises” (GSEs), they are private concerns, owned by ordinary shareholders and operating without government guarantee. But nobody believes that the government would let them fail, so they enjoy the implicit subsidy of a public guarantee and raise money on correspondingly advantageous terms.
Exploiting this subsidy, Fannie and Freddie were to mortgage securitisation what Michael Milken was to junk bonds. For years, mind you, securitisation was seen as a very good thing. Alan Greenspan, the former chairman of the Federal Reserve, was constantly praising it as a way to broaden access to housing finance. But securitisation poses problems when housing loans go bad because it makes loans more difficult to restructure. By removing the risk from the books of the originator, it also encourages unsafe lending. One imagines that mortgages based on no documentation of borrowers’ earnings and drive-by appraisals of the property’s value would have been less popular if the lender had expected to keep the loan on its books. At the very least, the securitisation that Fannie and Freddie pioneered and promoted has turned out to be a mixed blessing.
The GSEs have significant exposure to the subprime market in their own right – to the tune of $170bn at midyear – but they are more deeply implicated than that. As James Hamilton of the University of California, San Diego explained at the Jackson Hole meeting of central bankers this summer, Fannie and Freddie powered the expansion of the mortgage business between 1990 and 2002, increasing their share of the market more than fourfold – a surge that was fuelled by their implicitly subsidised borrowing. Subsequently, as their pace of lending slowed, private mortgage-backed securities took up the running, but now with a growing emphasis on subprime mortgages. Perhaps, Mr Hamilton says, the market believed that the implicit subsidy to Fannie and Freddie was in effect extended to the new private lenders. Whatever it might say, the Fed could not countenance the failure of the GSEs. In setting interest rates to keep them afloat, it would protect the others as well.
Fannie and Freddie face mounting losses; they have capital adequacy difficulties; their shares have tumbled since the summer. Ofheo has been gamely trying to enforce its capital adequacy rules – and has been meeting resistance. This is no time to force sales of mortgages to shore up capital, say critics of that move. Just the opposite, they argue: Congress should be telling Fannie and Freddie to expand their role, buy up questionable subprime mortgages to help distressed borrowers and to heck with their capital ratios.
The case for doing that is easy to understand. Yet, depending on how bad this crisis becomes, such a policy would add to concerns about the enterprises’ solvency, bring closer the day when the government’s assurances of “no guarantees” will be put to the test and massively raise the stakes.
It is a pity, as always, to be starting from here – but the plain fact is, Fannie and Freddie are already too big to fail. The implicit subsidy embodied in that fact, married to private housing finance which is both lightly regulated (if at all) and recklessly innovative, has proven toxic. The first order of business must be to soften, so far as possible, the housing market crunch and the recession that might follow. If, for now, that means a bigger role for Fannie and Freddie, so be it. But the corollary should be a frank recognition of the enterprises’ public subsidy, a re-examination of their supposedly private status and a comprehensive new regulatory framework for the private lenders that operate alongside.
If that could be done before Fannie and Freddie actually go bust, so much the better.
