Fannie Mae was established as a government agency in 1938, during the Great Depression, to help make mortgages less expensive and more available. In 1968, Fannie was transformed into a government sponsored enterprise, which meant investors could now buy shares. Although partially privatized, it was widely regarded that the government would back Fannie if necessary. Several economists have referred to this as the privatization of profit and the socialization of risk.
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To guarantee mortgages, Fannie and Freddie buy the mortgages from lenders. They then bundle mortgages with similar interest rates and sell them to investors, guaranteeing the principal and interest payments at a rate typically about one quarter of a percentage point below the actual rates of the loans. They then pocket the difference to cover costs, including defaults.
By guaranteeing mortgages, Fannie and Freddie lower the cost of a mortgage – or the interest rate – by providing an insurance policy for investors against default. This increases the security of the investments, so investors are willing to accept a lower rate of return, which is passed along to homebuyers in the form of lower mortgage rates.
Fannie and Freddie also “own” loans that they purchase but don’t resell. This provides a source of income, presuming the interest they earn is sufficient to cover costs, including defaults.
Several things went wrong. Higher default rates meant Fannie and Freddie had to pay more to cover the loans they guaranteed. The spread they earned from the resale of mortgages was no longer sufficient to cover the cost of defaults. Also, there were likely some unwise management issues, including excessive spending on lobbying to keep legislators from tightening regulatory controls.
As financial conditions of both enterprises began to deteriorate, investors became nervous about buying Fannie and Freddie guaranteed mortgages. As a result, investors demanded higher rates of return on those investments, which put upward pressure on mortgage rates. Also, the prices of shares of Fannie and Freddie began to decline, which meant revenue streams began to decline; and the increased risk kept some investors away. This reduced the supply of money available for mortgage lending, placing upward pressure on mortgage interest rates. As a result, efforts by the Federal Reserve over the past year to lower interest rates didn’t make their way into mortgage markets.
In July, Congress authorized the U.S. Treasury to buy Fannie and Freddie shares and securities, to grant loans to the struggling enterprises, and to place them in a conservancy if agreed to by the leadership of the enterprises. The Treasury wasn’t granted authority to take over the enterprises unless the Federal Housing Finance Agency – the regulator of both enterprises – determined they were insolvent, meaning they could no longer meet their obligations. In September, the leadership of both enterprises agreed to hand over reigns to the government in exchange for financial help.
Treasury Secretary Henry Paulson placed Fannie and Freddie in a conservancy, under the management of the FHFA, and began injecting money into the enterprises through loans and the purchase of shares. New chief executives were appointed who are now looking at restructuring the enterprises to restore them to financial viability.
There are several reasons for the takeover. One was to restore faith in the Fannie and Freddie guaranteed mortgages. While it’s always been implied that the government would bail them out, there’s been uncertainty over the timing and extent of a bailout. By clearing this up, investment in the mortgages guaranteed by Fannie and Freddie has become more secure. The almost immediate result was a drop in mortgage rates by nearly one percentage point. The added security has the effect of increasing the number of investors and investor dollars. It also lowers the rate of return on investments as a tradeoff for the added security – the lower rates are then passed along to homebuyers.
So who pays for all this? You guessed it – the taxpayer. If the government makes loans to Fannie and Freddie that they cannot pay, then taxpayers will take the loss. If the government buys Fannie and Freddie guaranteed mortgages and those mortgages default – and Fannie and Freddie can’t cover them – taxpayers will cover it.
This doesn’t mean we’ll see a tax increase we can point to and say “this is because of the Freddie-Fannie takeover.” The more immediate effect will be an increase in the public debt. The government has decided to keep the Fannie-Freddie transactions off-budget, which means the spending won’t show up in official deficit or national debt figures. The perceived transient nature of the takeover has been cited as the reason for keeping the bailout off-budget; but it was probably also motivated by the fact that the deficit is already at record highs, and raising it could hurt the value of the dollar on the foreign exchange, as well as draw increased public scorn at home.
Most economists are of the opinion that Freddie and Fannie were too big to let fail. Most criticism of the takeover is not necessarily that this is the wrong thing to do at the wrong time. Instead, it goes back to the wisdom of public-private enterprise to begin with, since it has always been implied that the government would back up Fannie and Freddie to keep them from failing. This removed the incentive for wise investment, allowing these enterprises to become as large as they did. Also, lobbying prevented the expansion of regulation of the two enterprises, and their status as government sponsored enterprises provided exemption from many of the reporting requirements to which other publicly traded companies are subject.
Who is helped by the takeover? Most immediately are those in the housing and real estate market, including homebuyers, builders, realtors, and lenders. The added security of Fannie and Freddie led to an immediate drop in mortgage rates, stimulating this market. This could, however, be a double-edged sword. It was lower mortgage rates that got us into the mess we’re in now, because the lower rates meant a lowering of the standards for lending, which then led to higher defaults. Now, the lower rates could mean more risky loans; and thus mean more Fannie and Freddie losses, which now must be borne by taxpayers. The bailout could merely prolong the current market correction and could, in the longer term, add to the woes of the housing market by creating a new wave of defaults to be dealt further down the road. There’ll likely be some measures undertaken by the new Fannie and Freddie leadership to help keep people in their homes; but the cost of these measures will be borne by taxpayers.
Who is hurt? Most immediately are those holding Fannie and Freddie shares. One of the first actions of the takeover was to suspend payment of dividends. For many large investors, this accounted for a considerable amount of steady income, which will now be turned off in the midst of other economic problems. This is not necessarily the direct outcome of the takeover; rather, the takeover merely sped things up. As Fannie and Freddie’s financial condition worsened, it was only a matter of time before their stock prices would fall and dividends would be threatened.
Also hurt are taxpayers. While taxpayers won’t see an immediate tax increase to pay for all this, there will be an increase in the national debt – notwithstanding that the increase will be accounted for off-budget. This means servicing the debt will become more expensive and there’ll be less money left over for other government spending. This may lead to cuts in federal spending for other projects, including grant funding for programs at the state and local levels. This could lead to the curtailment or elimination of some programs, or tax increases at the state and local levels to fill the gap. If the national government chooses to finance the takeover through an expansion of the money supply; then that will stoke inflation, which is already a major concern, and the impact will be felt by American households who are already struggling with higher prices.
If you have any questions on the economy, please contact the CER at (520) 515-5486 or email us at cer@cochise.edu. Check out the CER’s website at www.cochise.edu/cer.
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