Fannie and Freddie Nationalized

The Federal Government announced today its takeover of Fannie Mae and Freddie Mac. Floyd Norris has a good column on the announcement. The problems there were a classic case of moral hazard. The two institutions had at least implicit federal guarantees, so they could borrow at low rates. But they were privately managed so they took risk to bolster profits. As Norris notes, they served two masters, and this really got them into trouble.

It was during the long housing boom that the seeds of destruction were sowed for Fannie and Freddie. They appeared to be very profitable, so pressures mounted for them to find ways to finance housing for poorer Americans, often living in areas where banks had historically been hesitant to lend. Congress set goals for such lending.

As the housing boom proceeded the share of home loans that they purchased increased dramatically. See this article from Jim Hamilton for some excellent analysis of the role of Fannie and Freddie in generating our current crisis. As Jim notes,

The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

The question is why did these two Government Sponsored Enterprises grow so fast? Part of it is the fact that Congress wanted more mortgage loans made to expand home ownership. And the bigger part is that Fannie and Freddie grew to earn more profits, using their borrowing advantage to grow their market share, with the taxpayer bearing the risk.