The system involving Fannie Mae and Freddie Mac needs to be reformed. According to the Wall Street Journal, “Many in Washington say they want to get rid of the [Fannie and Freddie], but they want to preserve many of the benefits that those companies enabled – namely, providing a steady source of relatively chap 30-year, fixed-rate mortgages”. Fannie and Freddie do not make loans, but package mortgages into securities that are sold to investors. As mortgage guarantors, Fannie and Freddie promise to pay investors back when the loans default. On the one hand, Fannie and Freddie serve an important role as middlemen bringing buyers and sellers together. On the other hand, Fannie and Freddie stick the government with a huge bill when loans default.
The government played a critical role in the housing bubble. Burton Malkiel writes in A Random Walk Down Wall Street, “The government itself played an active role in inflating the housing bubble. Under pressure by Congress to make mortgage loans easily available, the Federal Housing Administration was directed to guarantee the mortgages of low-income borrowers”. The government vehicle that guaranteed these loans was Fannie and Freddie. Creating a classic moral hazard problem, the government takes on a majority (if not all) of the risk. As a result, lenders loosened their standards and provided loans to noncredit worthy individuals because the government was there to assume the risk. Although there are many other factors that contributed to the housing bubble, an important factor was government policies that encouraged lenders to lower their standards.
After the initial increase in demand caused by low-income borrowers entering the market, the housing bubble continued to grow in size due to a positive feedback loop. According to Malkiel, “The initial rise in prices encouraged even more buyers. Buying houses or apartments appeared to be risk free as house prices appeared consistently to go up. And some buyers made their purchases with the objective not of finding a place to live but rather of quickly selling (flipping) the house to some future buyer at a higher price”. Speculators, who purchased real estate with the intention of selling for a profit, contributed to strong demand and further pushed prices upwards. The implicit government guarantee essentially eliminated credit risk for investors, which is the risk of default. The belief that prices will continue to rise created “castles in the air”.
As it always does, the bubble finally popped. Interest rates, which were low in the years prior to the financial crisis, began to rise (i.e. interest rate risk). Demand for houses slowed down and prices fell. Mortgages grew to exceed the value of the underlying asset (i.e. the house or apartment). As a result, homeowners chose to default and allow the lender to repossess the asset. The increase in the supply of homes caused prices to fall drastically. The burst of the housing bubble brought on the recent financial crisis in which Fannie and Freddie defaulted. In September 2008, the government bailed out Fannie and Freddie.
Fannie and Freddie caused many problems as quasi-public institutions. According to the Wall Street Journal,
“In addition to serving as mortgage guarantors, the firms also amassed over the last two decades huge investment portfolios, which helped them generate larger returns to appease shareholders. The companies claimed that these portfolios helped reduce borrowing costs for homeowners, but critics argued that they simply used their implied government guarantee to profit between the spread on those investments and the cheaper debt-funding costs”.
Using the implicit government guarantee to benefit in the market place is a misuse of power. Fannie and Freddie are a duopoly, which were able to reap huge profits before being bailed out. Currently, lawmakers are working on a new system in which the good aspects of Fannie and Freddie would be preserved. According to the Wall Street Journal, “The plan, by Senate Banking Committee leaders Tim Johnson (D.,S.D) and Mike Crapo (R., Idaho), calls for replacing Fannie and Freddie with a new system of federally insured mortgage securities in which private insurers would be required to take initial losses before any government guarantee would be triggered”. Forcing private insurers to face losses would hopefully discourage irrational risk taking by decreasing moral hazard. Although there is uncertainty surrounding the future of Fannie and Freddie, the need for change is clear and there are certain agreed upon principles – make the “implied” guarantee explicit, get rid of those investment portfolios, require more capital and tighter regulation.
The real questions is whether Fannie and Freddie will remain (in a reformed system) or will be replaced. If replaced, then who will be the successors? I believe this is a very tough question to answer. Although big banks could easily handle this role, this would intensify concerns about certain institutions being too-big-to-fail. I look forward to hearing more about the Senate Banking Committee’s plan.