GUARANTEED TO FAIL

PRINCETON UNIVERSITY PRESS

Contents

Chapter One

The GSEs play an extraordinarily successful double game ... [telling] Congress and the news media, "Don't worry, the government is not on the hook"—and then turn around and tell Wall Street, "Don't worry, the government really is on the hook."

—Richard Carnell (Fordham University Law Professor and former Assistant Secretary of the Treasury), Senate testimony, February 10, 2004

In 1818, a nineteen-year-old English girl, Mary Shelley, published her first novel. The novel tells the story of a young, talented scientist who discovers how to create life from the inanimate. Collecting old human bones and tissue, the scientist constructs a man from scratch and brings him to life, only to be disgusted by his appearance and shape, calling him the Monster. The scientist deserts the monster, and, left to its own devices, his creation causes havoc and mayhem. In the finale of the story, as the scientist confronts the monster, the monster eventually destroys its creator and, stricken with grief, takes its own life. Shelley decided that the name of the talented scientist should be the title for the novel: Frankenstein.

Former executives of Fannie and Freddie, members of Congress, and past administration officials all talk about the good work of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac; and, they will add, if it were not for the equivalent of an economic asteroid hitting the markets, all would be fine. They will point to affordable housing goals and the benefits to the underprivileged.

We are skeptics.

If the government was Doctor Frankenstein, surely the GSEs were its monster. Born of a well-intentioned and economically efficient goal of creating liquidity in the secondary mortgage market, these institutions morphed into typical profit-taking firms with an important exception—the government served as the backstop for the majority of their risks. While the government subsidies went primarily to CEOs, shareholders, and wealthier homeowners, the costs were borne by society as a whole. As of 1970, when Fannie Mae had been recently privatized and Freddie Mac was newly created, they represented 4.4% of the mortgage market; by 1991, they captured 28.4%; by the time of the financial crisis, they held 41.3%, with a combined $1.43 trillion mortgage portfolio and $3.50 trillion in mortgage-backed security (MBS) guarantees; and, as of August 2010, they had left the U.S. taxpayers with a hit of close to $150 billion, with some projections anticipating that this figure will more than double in years to come, with substantial downside risk.

We start by describing what the GSEs do—what roles they play in the mortgage markets. We then trace the origins of Fannie Mae and Freddie Mac, what special features of these enterprises caused the financial markets to treat them specially, and what allowed them to register their staggering growth.

1.1 the ESSENCE OF THE GSES

What exactly do Fannie and Freddie do? The GSEs are engaged in two somewhat related businesses: residential mortgage securitization (currently about $3.5 trillion) and residential mortgage investment (currently about $1.7 trillion).

In the securitization business, the GSEs buy mortgages from originators (mostly fixed-rate, single-family home mortgages, although they also buy some adjustable-rate mortgages and some mortgages in the multifamily market); they form pools of these mortgages (so that the "law of large numbers" reduces the variability in outcomes that might arise from a single mortgage); and they issue (sell) "pass-through" mortgage-backed securities that are formed from these pools to investors. These MBS represent claims on the interest and principal repayments that are "passed through" from the pool of mortgage borrowers to the securities investors (minus various fees).

Because the investors have no direct knowledge of the creditworthiness of the mortgage borrower, they need to be reassured that they will receive the promised interest and principal repayments. Both Fannie Mae and Freddie Mac provide guarantees to investors in their MBS against the risk of default by borrowers of the underlying mortgages. In return, both charge a "guarantee fee."

Although the GSE guarantee (so long as it can be honored) removes the credit risk from the securities, the MBS investor is still subject to interest rate risk. Any long-lived fixed-rate debt instrument carries interest rate risk. When interest rates for new securities are higher than the interest rate on an existing (but otherwise comparable) security, the value of the latter decreases; when interest rates for new securities are lower, the value of the existing security increases. However, for fixed-rate mortgages (and the MBS that are formed from them), the interest rate risk for the investor is heightened, because mortgage borrowers are usually able to prepay their mortgage (and, in the United States, do so without paying any fee or penalty).

The second business for the GSEs is mortgage investment. They buy and hold residential mortgages (or, more often, their own MBS). The funding for these investments comes overwhelmingly from issuing debt. They earn net income on the "spread": the difference between the interest yield on the mortgages that they hold and the interest rate on the debt that they have issued. Because their debt is implicitly guaranteed by the U.S. government, GSE debt is relatively risk insensitive. Further, the GSE shareholders do not pay a premium for these government guarantees or bear the full cost of their failure. Hence, from the GSEs' standpoint, the cost of issuing debt is less than the costs of issuing equity, and they have a strong incentive to try to leverage themselves as much as possible—to issue as much debt and as little equity—to the extent that their creditors and regulators will permit. By owning these on-balance-sheet mortgages, the GSEs are exposed to interest rate risk as well as credit risk.

The timeline in the appendix lays out the key reforms and events punctuating the evolution of U.S. housing finance policy from its inception in the 1930s all the way to the current state of affairs. There have been three somewhat distinct phases: the early phase, in the Depression era, helps us to understand how and why the federal government established a foothold in mortgage finance; the privatization phase, starting in the late 1960s, paved the way for the GSEs' expansion on the back of government guarantees; and the debt phase, starting in 1992, mandated the GSEs to serve "mission" goals while simultaneously being accorded highly favorable regulatory treatment with regard to their leverage. The end result is the present debacle of Fannie Mae, Freddie Mac, and U.S. housing finance.

1.2 BEGINNINGS

The origins of Fannie Mae and Freddie Mac go back to the era of the Great Depression. The stock market crash of 1929–33, and the failures of more than 8,000 commercial banks, as well as thousands of savings and loan (S&L) institutions (which are frequently described as "thrifts") inflicted widespread economic misery across the United States.

Among the victims of this trauma was the residential mortgage lending system. Before the mid-1930s, the standard mortgage loan had a five-year term, with interim interest payments and a required balloon payment for the full amount at the end of five years. The expectation was that the mortgage would be refinanced at that time. Banks and S&Ls were the primary originators and holders of mortgages, although life insurance companies also were significant holders of mortgages (especially of multifamily mortgages). The economic implosion of the early 1930s, however, meant that many lenders were unwilling to refinance, and many borrowers could not repay. Home foreclosures were widespread; and the losses on the foreclosed loans contributed to the failures of thousands of banks and S&Ls.

The first piece of legislation that made any effort to address these issues preceded the Roosevelt administration's "New Deal." In 1932, during the final year of the Hoover administration, the Congress created the Federal Home Loan Bank System: 12 regional Federal Home Loan Banks (FHLBs) that were owned by the S&L institutions and a few life insurance companies in the regional territories of the FHLBs and that were regulated by a new federal agency: the Federal Home Loan Bank Board (which would soon also be the national regulator of S&Ls). The FHLB System could borrow funds in the capital markets, and the individual FHLBs could turn around and lend the funds to their member-owners, who were the primary originators of mortgages at the time. Because the FHLB System was a creation of the federal government, it could borrow at favorable rates, and the FHLBs could pass those favorable rates on to their member-owners.

In an important sense, the FHLB System was an early "government-sponsored enterprise" (although that term was not used until decades later). It reflected for the first time what was to become a distinguishing feature of the U.S. housing finance for next eight decades: borrowing in the name of the government (explicitly or implicitly) to promote household borrowing in the form of mortgages.

With the New Deal came a flurry of legislation that affected the financial system, with some of the legislation leaving a lasting impact on residential mortgage finance. This included the creation of the Federal Housing Administration (FHA) in 1934 to offer mortgage insurance to lenders on qualified mortgages and of the Federal National Mortgage Association (FNMA) in 1938 to purchase FHA-insured mortgages. Funding for these purchases came through the FHA's issuance of bonds in the capital markets. The FNMA subsequently acquired the nickname "Fannie Mae" from the bond traders who dealt in those bonds, and the nickname stuck.

Over the next two decades, Fannie Mae's scope was expanded. First, it gained the authority to buy the mortgages insured by the Veterans Administration (VA), another creation of the Congress, the powers of which included the guaranteeing of qualifying mortgages—in this case, the mortgages of veterans. Then, Fannie Mae's status as a government agency was confirmed, and it was made exempt from state and local income taxes, which was (and is) a substantial competitive advantage relative to private financial firms. As another advantage, the Federal Reserve Banks were required to perform various services for Fannie Mae. And Fannie Mae was to provide "special assistance" for certain kinds of mortgages, a precursor to the "mission" regulation of the GSEs in the 1990s and 2000s. The debt that Fannie Mae issued came to be known as "agency" debt, or just as "Agencies" (a label that persisted through the subsequent morphing of Fannie Mae, and which has applied to Freddie Mac's debt as well).

Through these steps, the government's foothold in mortgage finance was born.

From its chartering in 1938 through the middle of the 1960s, Fannie Mae was a relatively minor presence in the overall residential market—more symbolic than substantive. The major institutional holders of residential mortgages during this period were S&Ls, commercial banks, and life insurance companies. Somewhat paradoxically, Fannie Mae grew the most on the back of the U.S. government only when the government began to "disown" it, though never fully.

1.3 PRIVATIZATION OF THE GSES

By far, the most important legislation affecting Fannie Mae was its conversion into a private company in 1968. It was primarily for accounting purposes. The Johnson administration wanted Fannie Mae privatized, so as to remove its debt from the federal government's books, thereby reducing the size of the national debt. In addition, a change in federal budgeting procedures at the time would have counted Fannie Mae's net purchases of mortgages as current government expenditures, which would have meant that those net purchases would have added to recorded federal budget deficits—something that any presidential administration would want to avoid doing during its own term.

The privatization meant that Fannie Mae was spun off to the private sector and became a publicly traded company, with its shares listed on the New York Stock Exchange (NYSE). However, Fannie Mae retained its federal charter and the special status and privileges that went with it. Fannie Mae also had its own special regulator: the Department of Housing and Urban Development (HUD), which had been created as a cabinet-level department in 1965 and retained some regulatory powers over Fannie Mae. Another prominent indicator of the specialness of Fannie Mae, despite its apparent structure as just another private (publicly traded) company, was the power of the president of the United States to appoint five board members to the Fannie Mae board of directors. No other company that was listed on the NYSE had presidential appointees on its board.

Simultaneously with the spinning off of Fannie Mae into the private sector, the same 1968 legislation created the Government National Mortgage Association (GNMA, which was subsequently dubbed "Ginnie Mae") within HUD as an agency that would securitize FHA- and VA-insured mortgages. And next to arrive on the scene was Freddie Mac in 1970. Ownership of Freddie Mac was placed with the Federal Home Loan Bank System, which was owned by the S&L industry. The three board members of the Federal Home Loan Bank Board became the board members and de facto regulators of Freddie Mac. (Shares of Freddie Mac would be made available to the general public almost two decades later.) Freddie Mac was expected to buy mortgage loans from the S&L industry and securitize them, although it was not restricted from buying mortgage loans from other originators. Because Freddie Mac (like Fannie Mae) was the creature of Congress, it too was a GSE.

Fannie Mae, too, received authorization to expand its mortgage purchases to encompass mortgages that were not insured by FHA or VA. However, both Fannie Mae and Freddie Mac were restricted (by HUD and the Bank Board, respectively) in the size of mortgage loan that they could purchase, either for securitization or for holding in their portfolios. This maximum loan size came to be known as the "conforming loan" limit. Mortgages that exceeded the conforming limit came to be known as "jumbos." From 1975 to 1977, for example, the conforming loan limit was $55,000; from 1977 to 1979 the conforming loan limit was $75,000. In 1980 the limit was raised to $93,750 and was subsequently linked to an index of housing prices. For comparison purposes, the median price of the sale of an existing house was $35,300 in 1975 and was $62,200 in 1980; the median price of a new house was $39,300 and $64,600 in those two years, respectively. Thus, the conforming loan limit was substantially above median prices, whether measured by sales of existing homes or new homes; this pattern has continued to prevail to the present day, explaining the reach of the GSEs in affecting housing finance of a substantial proportion of the U.S. households.

What is not commonly known is the financial difficulty that was experienced by Fannie Mae in the early 1980s. Like the savings and loan industry that it resembled (because, like the S&L industry, it was borrowing from the public and holding fixed-rate mortgages in its portfolio), Fannie Mae was squeezed by the high interest rates of the late 1970s and early 1980s. Holding a portfolio of long-lived fixed-rate mortgages that had been originated at lower interest rates than were prevailing in the early 1980s, it ran net losses in the early 1980s. Although Fannie Mae remained solvent on a book-value basis, there was widespread recognition that it was insolvent on a market-value basis. It survived the experience, however, and lower interest rates after 1982 eventually provided financial relief.

The savings and loan industry was not so fortunate. It was a preview of the financial storm that would crush the financial system some 25 years later. The interest rate squeeze and a poorly structured deregulation of the industry in the early 1980s led to rapid growth in nontraditional investments in the mid-1980s and the eventual insolvencies of hundreds of S&Ls by the late 1980s and early 1990s. The federal government, through yet another agency (the Federal Savings and Loan Insurance Corporation, or the FSLIC), was guaranteeing the deposit liabilities of the insolvent S&Ls. Hence, as in the financial crisis of 2007–9, it was the federal government that bore the net losses of these insolvencies. The bill at the time came to about $150 billion. In response to the interest rate squeeze of the

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Excerpted from GUARANTEED TO FAILby VIRAL V. ACHARYA MATTHEW RICHARDSON STIJN VAN NIEUWERBURGH LAWRENCE J. WHITE Copyright © 2011 by PRINCETON UNIVERSITY PRESS. Excerpted by permission of PRINCETON UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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