Fannie and Freddie

There is renewed discussion about what to do with Fannie and Freddie. In today's NYTimes Andrew Sorkin channels Barney Frank to explain why reform will be difficult.

More important, shutting down Fannie and Freddie and having the private market step in, as politically popular a sound-bite as that may be, is economically unfeasible. For better or worse, Fannie, Freddie and Ginnie Mae were behind 98 percent of all mortgages in this country so far this year, according to the Mortgage Service News. Pulling the rug out from under them would be pulling the rug from under the entire housing market as it continues to struggle.

The GSE's may have repackaged 98 percent of all mortgages in the country, but they did not finance them. That still came from savers. The GSE's, after all, still need funds just to survive. The real question is why the private market cannot package and sell bundles of mortgages in the absence of the GSEs? We know they did this before the financial crisis.

Presumably, the private markets are less willing now to refinance mortgages with very low down payments. They probably have learned from their mistakes. The pressure to keep the GSE's derives from the desire to continue to make risky loans that the private markets won't make.

So the question is who did not learn from the crisis, private markets or the government?

Fannie and Freddie Knew the Risks

This article in the Washington Post reveals emails that show analysts at Fannie Mae and Freddie Mac knew of the risk associated with subprime and Alt A loans, but that top officials refused to get out of this market. Fear of being irrelevant in the mortgage market drove their decision apparently.

The chief credit officer of Fannie Mae

warned that securities backed by these loans might not be as safe as they seemed. Fannie reported them as carrying the top grade given by credit-rating agencies, AAA, but Marzol cast doubt on that. "Although we invest almost exclusively in AAA rated securities, there is concern that rating agencies may not be properly assessing the risk in these securities," he wrote.

Despite these concerns, Fannie continued to push into this new market. A business presentation in 2005 expressed concern that unless it didn't, Fannie could be relegated to a "niche" player in the industry. Mudd later reported in a presentation that Fannie moved into this market "to maintain relevance" with big customers who wanted to do more business with Fannie, including Countrywide, Lehman Brothers, IndyMac and Washington Mutual.

This certainly does not mean that Fannie and Freddie caused the crisis, but it shows the extent to which they played along, and joined the party at the worst possible time.

More Fannie Losses

Fannie Mae reported quarterly losses (also here) of $29 billion for the third quarter. This is a huge amount of losses, greater than all of Fannie's profits from 2002 to 2006 -- the height of the boom in housing. This suggests that we have not yet reached the bottom of the housing boom.

It is also instructive of the unintended consequences of government policy. Apparently, Fannie is having great trouble refinancing its bonds. The reason is that as a GSE Fannie has only an implicit government guarantee. But banks now have much more explicit government guarantees, indeed many are partially government owned now. So the costs of borrowing for Fannie (and Freddie) are much higher. This will make it harder for Fannie and Freddie to extend lending which the government wishes they would.

Kayshap and Diamond on Bailouts and Lehman Brothers

Anil Kayshap and Douglas Diamond had a very good guess post at Freakonomics on the rationale behind the bailouts of Fannie and Freddie and AIG, and the decision to let Lehman collapse.

Update on Role of China in Fannie -Freddie bailout

The WSJ has an article on the bailout of Fannie and Freddie which illuminates the role of China and other foreign investors. Here is a relevant portion:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Like many investors, foreign governments, particularly central banks and sovereign-wealth funds, believed the U.S. government implicitly stood behind Fannie and Freddie and would prop them up to prevent a failure.

The point to remember is that foreign investors hold a lot more (an order of magnitude more) US assets then their holdings in Freddie and Fannie. So the threat to withdraw even some of them could have destroyed many other financial institutions.

More on the bailout

Most of the analysis of the Treasury's takeover of Fannie and Freddie focuses on the need to cope with the housing crisis. But the most important motivation to do this now was to prevent a financial crisis. It is important to note that a large portion of the debt of the two corporations was held by foreigners.

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

This capital inflow is a response to large US current account deficits. The debt of the GSE's, while not explicitly guaranteed, clearly bore an implicit Federal guarantee (as is now totally evident). Foreign investors who purchased GSE debt were naturally worried. If the GSE's went bankrupt they would perhaps gain cents on the dollar. The bailout announced by the Treasury will hurt shareholders, but will probably keep bondholders whole. Hence, the bailout reassures foreign investors at a time when we need them.

Of course what remains to be seen is whether the current bailout plan will suffice. As many have noted (for example, Paul Krugman here, or Mohamed El-Erian here), we are now in a process of de-leveraging. This is the reverse of the process in the boom when leverage is used to maximize returns. Now the race to safety means a rush to sell assets to bolster balance sheets. But what is good for the individual may not work for the economy as a whole. The rush to sell drives down prices which further worsens balance sheets and leads to more selling. Liquidity dries up. This is Irving Fisher's debt deflation. Japan went through this in the 1990's. Can we escape it?

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.