Fannie Mae and Freddie Mac: The Worst of Both Worlds
I am not an expert on financial matters, but I've been following financial news for the last ten years or so. I read it because I find the workings of the market and businesses ... fun. Some people like to read about politics or international incidents or local crime; me, I like hearing about why companies are succeeding or failing, why they're making the decisions they do. Business, at its root, is all about the things people do every day; maybe that's why it interests me.
It's been an interesting time for business news recently, in the Chinese proverb sense. Some of this raises the kind of passion in me that most people reserve for political issues like abortion.
So just to warn you: this is a rant. I am ranting about mortgage lending, which is very topical if not normally considered the subject of ranting. I will endeavor to give some useful information and not be boring, but my biases will color my presentation. But I do know that Fannie Mae and Freddie Mac didn't really eat babies, kick puppies, cause global warming, or single-handedly destroy the global financial system. Honest.
*
Nine or ten years ago, when I was still new to banking, my boss talked to me about Baby Bank's plan to hire a new loan officer. "He's going to make mortgage loans for us to sell on the secondary market."
"Oh? How's that work?" Baby Bank did very few home loans, and I'd always wondered why not.
"We find borrowers who want loans against homes, and make them loans according to Fannie Mae's standards. Then we sell them to another bank, who pays us a fee. Then that bank sells them to Fannie Mae, who pays a fee to that bank to service the loans, and packages the loan together with other loans and sells them to investors as securitized investments ... bonds, basically."
"Investors ... like ... banks?" I said. "Like us?"
"Yes."
"Doesn't this sound ... unnecessarily complicated to you? Why don't we just lend the borrower the money ourselves and keep the loan?"
"They offer much better rates than we can. Twenty or third points better. We can't match their rates, so the only way for us to do these kinds of loans is to offer their rates and sell them the loans."
"Which are paying fee slices to two other parties and making a profit for Fannie Mae too? How do they do that?"
"I have no idea."
Thus began my distrust of the FMs. I learned more about them over the years, none of which made me like them any better. After we hired the new loan officer, I went to a seminar with him on how to make loans that met their guidelines. This would've been in '98 or '99. They touted products for customers with high credit scores that required downpayments of only 5% of the sale price and waived requirements to provide proof of income and other documentation they deemed superfluous.
Fannie Mae and Freddie Mac are, or rather, were, government-chartered institutions with a mandate to increase home ownership through loans to American home buyers and owners. However, they were not government-owned nor government-guaranteed. They were a private company. ("Private" here in the sense of "not government owned". They're publicly traded on the stock market, like Microsoft or Lehman Brothers.) When they made money, their stockholders benefited. If they lost money, their stockholders, in theory, lost money.
Except that no one ever expected the latter to happen. The FMs offered rock-bottom rates for their loans to consumers. Those who bought the securitized investments received commeasurately low rates for the investments. Because everyone, and I mean everyone, thought that if those investments ever nose-dived the Feds would bail out the FMs.
Meanwhile, the FMs worked at gobbling up the market, which is easy to do when you're offering the best rate in town. They doled out tens of millions of dollars lobbying Congress for less oversight and extensions to their charter. They wanted to raise the cap on the size of loans they could make, and lower their standards for the quality of loans they could make.
They are, as a result, huge. They own or guarantee roughly half the housing market in US. That's about six trillion dollars. Not billion. Trillion. 6,000,000,000,000. Fun comparison: the entire United States debt is a bit under ten trillion. But bear in mind that this six trillion is not money owed *by* the FMs -- it's money owed *to* them or to the investors they've sold it to. The money gets funneled around every which way. Also, $6 trillion is the face value; a substantial fraction of that portfolio is severely devalued as the result of the mortgage market meltdown. How much of it? No one knows yet. That's part of the problem. This isn't because the FMs are evil and trying to hide their losses, incidentally. It's because the market is still melting down and no one knows when it will stabilize or where.
However, the FMs, like everyone other lending institution in the world, is leveraged. The right analogy isn't "I took $10,000 out of my savings account and lent it to Bob, who didn't pay me back and now I'm out the money, wah." The analogy is closer to "I borrowed $10,000 from my bank and lent it to Bob, who didn't pay it back and now I have to file for bankruptcy." But it's more complicated than that, because the investors have varying levels of recourse. So: "I took $100 from my savings account, had Mary chip in $8000 that she'd only get paid back if Bob paid me back in full, had David chip in $1000 on the condition that he'd get paid back by Bob first, and borrowed $900 from a bank myself, and lent $10,000 to Bob" is a little more accurate. I am both simplifying and making up the ratios; I don't know the exact details of Fannie or Freddie's tens of millions of deals.
And of course, having all those extra people involved makes the chain a disaster when it unwinds, because at every step of the way someone will look for someone else to blame. Everyone's looking at the paperwork for loopholes, and if they find anything, they sue. The investors sue FM, FM sues the loan servicer, the loan servicer sues the broker. Also, since every loan is owned by a pool of investors and this complex chain of intervening layers, no one actually has the authority to renegotiate with a struggling borrower. The complexity of the chain forces foreclosure even when foreclosure is a lousy option, because the contract allows no other possibility. This problem is endemic to the mortgage market, not unique to the FMs, but it's still one of their problems.
Now, our problem with the FMs is multifold. Arguably, they never should have been chartered. Having been chartered, they should have been stuck with their original mission of increasing home ownership among low-income citizens, and not allowed to expand in every direction. Having been allowed to expand in every direction, they should have been subject to a whole pile more scrutiny. Congress made this problem, and Congress had a multitude of chances to rein it in and chose not to. Anyone who looked could see that the FMs were a disaster waiting to happen. The Wall Street Journal has been preaching against them for years. But the FMs were allowed to sail on. Their meltdown was their own doing: they're the ones who provided the financing for the run-up in housing prices in the first place.
I hate -- and unless you have been watching these people steal business from your bank for years based on lies and political incest, you cannot understand the depth and passion of my hatred -- I hate that the Feds bailed them out. Because, of course, that's the whole reason they had this giant competitive advantage over the rest of the industry; that's the way they drove the rest of the industry into increasingly risky ventures in a vain effort to compete. Because everyone always knew that they'd get bailed out. The feds wouldn't let them fail.
But, even more depressingly, I know that at this stage of the game it's much too late for the feds to do anything else but bail them out. The FMs can't be allowed to simply fail and force all their stockholders and all those buyers of securitized investments to take a bath. Because that's everyone. Everybody holds those investments. They're considered almost as stable as Treasury bonds (because, you know, everyone "knew" the US gov't would guarantee them in the end -- and look! they were right! *FUME*) As bad as the whole premise of the FMs was and as much as they deserved to fail, their collapse would take down the global market. It wouldn't be quite as bad as the US federal government defaulting on its debt (that would be TEOTWAWKI), but it'd be close.
So the US taxpayer will bail them out, because the US taxpayer was already going to get screwed one way or the other and this way is cheaper than another Great Depression would be.
Not that I'm not bitter.
In conclusion:
The FMs are an example of "private profit, public risk". For decades, the FMs raked in the cash for their shareholders and investors. Now that their bets have finally soured, the US taxpayer is going to pay for their risks. This is not a failure of the free market, because the free market didn't make the FMs: Congress did. The FMs represented the worst aspects of the market and government; it didn't even have the benefit of a nationalized institution where at least the taxpayer makes money when the agency.
I'm not saying that everything driving prices in the market down right now is the fault of the FMs. Lehman Bros. filing for bankruptcy is pretty much the result of normal free market forces. But this rant is long enough already. If I muster up the energy I'll write more about that later.
It's been an interesting time for business news recently, in the Chinese proverb sense. Some of this raises the kind of passion in me that most people reserve for political issues like abortion.
So just to warn you: this is a rant. I am ranting about mortgage lending, which is very topical if not normally considered the subject of ranting. I will endeavor to give some useful information and not be boring, but my biases will color my presentation. But I do know that Fannie Mae and Freddie Mac didn't really eat babies, kick puppies, cause global warming, or single-handedly destroy the global financial system. Honest.
*
Nine or ten years ago, when I was still new to banking, my boss talked to me about Baby Bank's plan to hire a new loan officer. "He's going to make mortgage loans for us to sell on the secondary market."
"Oh? How's that work?" Baby Bank did very few home loans, and I'd always wondered why not.
"We find borrowers who want loans against homes, and make them loans according to Fannie Mae's standards. Then we sell them to another bank, who pays us a fee. Then that bank sells them to Fannie Mae, who pays a fee to that bank to service the loans, and packages the loan together with other loans and sells them to investors as securitized investments ... bonds, basically."
"Investors ... like ... banks?" I said. "Like us?"
"Yes."
"Doesn't this sound ... unnecessarily complicated to you? Why don't we just lend the borrower the money ourselves and keep the loan?"
"They offer much better rates than we can. Twenty or third points better. We can't match their rates, so the only way for us to do these kinds of loans is to offer their rates and sell them the loans."
"Which are paying fee slices to two other parties and making a profit for Fannie Mae too? How do they do that?"
"I have no idea."
Thus began my distrust of the FMs. I learned more about them over the years, none of which made me like them any better. After we hired the new loan officer, I went to a seminar with him on how to make loans that met their guidelines. This would've been in '98 or '99. They touted products for customers with high credit scores that required downpayments of only 5% of the sale price and waived requirements to provide proof of income and other documentation they deemed superfluous.
Fannie Mae and Freddie Mac are, or rather, were, government-chartered institutions with a mandate to increase home ownership through loans to American home buyers and owners. However, they were not government-owned nor government-guaranteed. They were a private company. ("Private" here in the sense of "not government owned". They're publicly traded on the stock market, like Microsoft or Lehman Brothers.) When they made money, their stockholders benefited. If they lost money, their stockholders, in theory, lost money.
Except that no one ever expected the latter to happen. The FMs offered rock-bottom rates for their loans to consumers. Those who bought the securitized investments received commeasurately low rates for the investments. Because everyone, and I mean everyone, thought that if those investments ever nose-dived the Feds would bail out the FMs.
Meanwhile, the FMs worked at gobbling up the market, which is easy to do when you're offering the best rate in town. They doled out tens of millions of dollars lobbying Congress for less oversight and extensions to their charter. They wanted to raise the cap on the size of loans they could make, and lower their standards for the quality of loans they could make.
They are, as a result, huge. They own or guarantee roughly half the housing market in US. That's about six trillion dollars. Not billion. Trillion. 6,000,000,000,000. Fun comparison: the entire United States debt is a bit under ten trillion. But bear in mind that this six trillion is not money owed *by* the FMs -- it's money owed *to* them or to the investors they've sold it to. The money gets funneled around every which way. Also, $6 trillion is the face value; a substantial fraction of that portfolio is severely devalued as the result of the mortgage market meltdown. How much of it? No one knows yet. That's part of the problem. This isn't because the FMs are evil and trying to hide their losses, incidentally. It's because the market is still melting down and no one knows when it will stabilize or where.
However, the FMs, like everyone other lending institution in the world, is leveraged. The right analogy isn't "I took $10,000 out of my savings account and lent it to Bob, who didn't pay me back and now I'm out the money, wah." The analogy is closer to "I borrowed $10,000 from my bank and lent it to Bob, who didn't pay it back and now I have to file for bankruptcy." But it's more complicated than that, because the investors have varying levels of recourse. So: "I took $100 from my savings account, had Mary chip in $8000 that she'd only get paid back if Bob paid me back in full, had David chip in $1000 on the condition that he'd get paid back by Bob first, and borrowed $900 from a bank myself, and lent $10,000 to Bob" is a little more accurate. I am both simplifying and making up the ratios; I don't know the exact details of Fannie or Freddie's tens of millions of deals.
And of course, having all those extra people involved makes the chain a disaster when it unwinds, because at every step of the way someone will look for someone else to blame. Everyone's looking at the paperwork for loopholes, and if they find anything, they sue. The investors sue FM, FM sues the loan servicer, the loan servicer sues the broker. Also, since every loan is owned by a pool of investors and this complex chain of intervening layers, no one actually has the authority to renegotiate with a struggling borrower. The complexity of the chain forces foreclosure even when foreclosure is a lousy option, because the contract allows no other possibility. This problem is endemic to the mortgage market, not unique to the FMs, but it's still one of their problems.
Now, our problem with the FMs is multifold. Arguably, they never should have been chartered. Having been chartered, they should have been stuck with their original mission of increasing home ownership among low-income citizens, and not allowed to expand in every direction. Having been allowed to expand in every direction, they should have been subject to a whole pile more scrutiny. Congress made this problem, and Congress had a multitude of chances to rein it in and chose not to. Anyone who looked could see that the FMs were a disaster waiting to happen. The Wall Street Journal has been preaching against them for years. But the FMs were allowed to sail on. Their meltdown was their own doing: they're the ones who provided the financing for the run-up in housing prices in the first place.
I hate -- and unless you have been watching these people steal business from your bank for years based on lies and political incest, you cannot understand the depth and passion of my hatred -- I hate that the Feds bailed them out. Because, of course, that's the whole reason they had this giant competitive advantage over the rest of the industry; that's the way they drove the rest of the industry into increasingly risky ventures in a vain effort to compete. Because everyone always knew that they'd get bailed out. The feds wouldn't let them fail.
But, even more depressingly, I know that at this stage of the game it's much too late for the feds to do anything else but bail them out. The FMs can't be allowed to simply fail and force all their stockholders and all those buyers of securitized investments to take a bath. Because that's everyone. Everybody holds those investments. They're considered almost as stable as Treasury bonds (because, you know, everyone "knew" the US gov't would guarantee them in the end -- and look! they were right! *FUME*) As bad as the whole premise of the FMs was and as much as they deserved to fail, their collapse would take down the global market. It wouldn't be quite as bad as the US federal government defaulting on its debt (that would be TEOTWAWKI), but it'd be close.
So the US taxpayer will bail them out, because the US taxpayer was already going to get screwed one way or the other and this way is cheaper than another Great Depression would be.
Not that I'm not bitter.
In conclusion:
The FMs are an example of "private profit, public risk". For decades, the FMs raked in the cash for their shareholders and investors. Now that their bets have finally soured, the US taxpayer is going to pay for their risks. This is not a failure of the free market, because the free market didn't make the FMs: Congress did. The FMs represented the worst aspects of the market and government; it didn't even have the benefit of a nationalized institution where at least the taxpayer makes money when the agency.
I'm not saying that everything driving prices in the market down right now is the fault of the FMs. Lehman Bros. filing for bankruptcy is pretty much the result of normal free market forces. But this rant is long enough already. If I muster up the energy I'll write more about that later.