Monday, September 08, 2008

From De Facto to De Jure: The Nationalization of Fannie Mae and Freddie Mac

The weekend nationalization of Fannie Mae and Freddie Mac is nothing new. From their creation in the 1930s, these entities were government controlled. Whether government controlled them outright or had partially privatized them, government always called the shots. Government set terms on what types of mortgages they could offer, to whom, and in what amount. Most importantly, government provided a widely understood “implicit” guarantee of the debt issued by these entities. Unlike other financial institutions, Fannie Mae and Freddie Mac could issue debt (which was then lent out to mortgage borrowers) with the backing of the U.S. Treasury and Federal Reserve. That gave Fannie and Freddie an edge over private banks in making mortgage loans, by design. Reportedly, 50% of all outstanding mortgages are guaranteed by Fannie and Freddie, and as much as 75% of all new mortgages in recent years were issued by these agencies.

The government’s purpose in forming these entities was to make mortgages more widely available. Absent Fannie and Freddie, the other way to get mortgages has always been from private, profit-seeking banks, banks that had to safeguard their credit by striving to lend their money only to creditworthy borrowers. The only way Fannie and Freddie could out-compete these banks was by doing the one thing its government backing enabled it to do: lend to less creditworthy borrowers. This is a case of the bad credit driving out the good credit. In the space of 70 years, millions of uncreditworthy borrowers got mortgages as these government agencies pushed out the more prudent private banks and gained the largest market share in the mortgage market.

Now the loans are being called. The credit and stock markets are calling these loans en masse. The sheer weight of thousands of deadbeat borrowers has created a crisis that even the implicit guarantee of Fannie and Freddie’s debt by the U.S. government cannot ameliorate. So, this weekend the implicit guarantee has been made explicit.

That should make it fully clear to everyone, if it wasn’t during the past 70 years of the “implicit” guarantee. The lender to all these deadbeat borrowers, borrowers who didn’t qualify to get loans from private banks, is you, me, and everyone else in this country. We are all on the hook for the bad loans to our neighbors. That is socialism, and now it has been made explicit.


softwareNerd said...

The powers-that-be are really dragging this out. Even now, they aren't being super explicit. Has the government explicitly guaranteed the GSE obligations?

From what I've read, they they'll insert cash into the companies, by buying shares; and, they will also buy the MBS in the market, thus giving the creditors a way out at some price; but, there's no explicit guarantee of the debt -- it remains implicit and undefined. So, it seems they're still keeping the creditors guessing.

Burgess Laughlin said...

Thank you for this essay. It clears up issues garbled by mainstream media. Your essay also points to the need for objective history of such institutions (as you did in your Summer article in The Objective Standard, on the electric grid).

Yaron Brook and Onkar Ghate, in lectures to the 2008 Objectivist Conference, mention that they have many philosophy students passing through the Objectivist Academic Center. They would like to see more students in intellectual fields too. Drs. Brook and Ghate specifically mention the need for more students of history.

In about two weeks, Study Groups for Objectivists will be starting a very brief study group focusing on the Brook and Ghate lectures:

Galileo Blogs said...

I didn't follow the Freddie and Fannie takeover in enough detail to see whether the government formally and officially agreed to back the loans. At this point, now that they have taken over these entities, it would be a shocker if they fail to do so. If I owned some of these bonds (which I don't), I would bet that the government will honor them. The Treasury Secretary and other government officials have the look of frightened children on their faces; they simply cannot contemplate any sort of default by Freddie and Fannie. If I were a bond investor, I would take that frightened look to the bank and go long these bonds.

Of course, either way, whether the loans are honored by the federal government, or the government allows Fannie and Freddie to default, American individuals get stuck with the tab from this government-sponsored largesse handed out over many years to uncreditworthy home buyers.

Millions of Americans are on the hook as taxpayers or as bondholders, and even as future homebuyers if liquidity in the mortgage markets gets messed up temporarily by the government's actions, or if the government further regulates the mortgage industry as a follow-on to this takeover.

The best solution is to liquidate Fannie and Freddie in an orderly manner, and get the government out of the mortgage business. Lending to homeowners is a profitable business for prudently-run, private banks. Let them do it.

Best wishes for a successful study group. I am inspired by all of the Objectivist activism I see blossoming around me. It inspires me to act myself.

Valda Redfern said...

To second Burgess, thank you for a clear and concise account of what Freddie Mac and Fannie Mae actually are. I happened to know that they were creations of the New Deal and had always been state-controlled, but have still profited by your way of explaining it. The nature of these organisations has not come across at all in British reports of the latest idiocies.

softwareNerd said...

GB, Thanks for the reply.

I just read Paulson's statement about this. Unfortunately, he seems to imply that bond-holders are safe. That's too bad. I was hoping against hope that they would place a limit on the extent to which they will underwrite the debt of these companies, thus creating a slightly better precedent for the future.

Here's what he said:

"I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction. ..."
... ...
"These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS."

Galileo Blogs said...


I somehow get the impression that the British government has not subsidized home ownership to the same extent as the United States. For example, the U.S. tax code favors home ownership at the expense of renting, and subsidizes it through the various New Deal programs, such as Fannie Mae and Freddie Mac, and the Savings & Loan banking system.

So, this U.S.-style interventionism might seem somewhat foreign to you. If it is, you are fortunate!


Those statements by Secretary Paulson would be good if they were but a preamble to the statement: "And now we will liquidate Fannie Mae and Freddie Mac in an orderly fashion and permanently get government out of the home mortgage business. Private banks can and will provide this financial product to home buyers."

Alas, I do not expect he will do the right thing and utter these words. In pragmatic fashion, he will do no more than address the range-of-the-moment issue, leaving the fundamental problem of government intervention in the mortgage industry to fester and worsen.

softwareNerd said...

Yeah, GB, sadly, you're right about Paulson and his boss.

Even within the context of things that would have been politically feasible, his solution is the "safe" one: another low-quality patch in the levee. One can hear him thinking: "I'll be out of office soon; it's someone else's problem".

Yesterday, I came across a long article from August 2002, that gives a background on Fannie and Freddie. The accounts of their lobbying made me want to throw up.