Monday, July 19, 2010

The Fannie and Freddie Factor: Some myths simply won’t die.

If history were to write a paragraph on what caused this current recession, would it be correct to say that Fannie Mae and Freddie Mac encouraged financial institutions to make risky home loans to consumers who could not pay back their loans if the interest rates jumped? And that the consumers who lost their jobs, caused some mid to large financial institutions to fail and thus cause a cascade affect which nearly brought the entire financial network in the U.S. to its knees?

Well, if you get most of your information from Fox News and conservative talk-radio, you already know the answers to the above questions. And of course you probably subscribe to the idea that the cart always comes before the horse. Because the simple truth is that Fannie Mae and Freddie Mac were responding to highly unstable market conditions that had been in place for years when they started to go south in the late summer of 2008. The genesis of this crisis actually started almost ten years earlier during the Clinton Administration.

The repeal of the Glass-Steagall Act in 1999 allowed institutions like Citigroup and J.P. Morgan Chase to ostensibly ride both sides of the fence. On the one side they could continue as banks and underwrite mortgages to their lenders; on the other side they could act as investment brokers, repackage those loans and sell them to Wall Street. Because banks enjoy protections that ordinary investment firms do not, over time the packaged loans became riskier and riskier, as the pool of credit-worthy borrowers began to thin and the banks turned to sub-prime borrowers to fill the void. Eventually these no-doc stated income interest-only option-ARM no money down mortgages were being repackaged as “sound investments” and being sold as “stable assets” for pension plans to sink their money in.

It was kind of like that old game of musical chairs, only when the music stopped all the participants were left without a chair. Not only did the pension funds get stuck holding securities that were worthless, but the banks got hosed as well. They held many of these instruments on their books as a means of satisfying fixed-income requirements and using these assets as collateral. The resultant “write-downs” overwhelmed the banking industry as a whole. Had it not been for swift intervention by the Fed, the resulting domino cascade would have plunged the world into a depression even worse than the one in the 1930s.

Fannie Mae and Freddie Mac’s role in this tragedy has been badly misunderstood by many, and exploited by a few. For one thing neither had anything to do with the explosion of high-risk lending a few years ago. So says economist Paul Krugman. “In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.”

The reasons for this? According to Krugman there were two:  “Regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any sub-prime lending, because they can’t: the definition of a sub-prime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.”

If that was the case, then how did both get into so much trouble? Simple. Because of the sheer magnitude of the collapse in property values, even borrowers who put up twenty percent now had negative equity in their homes. The resultant delinquency rate severely taxed even those institutions that underwrote quality loans.

“Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.”

So why is it that we keep hearing from the Right erroneous charges of malfeasance against these two institutions? It all boils down to their status and a fundamental belief held by some that is rubbed the wrong way by that status. Both Fannie Mae and Freddie Mac were created by the Federal government to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. They now finance most of the mortgages made in the United States.

Although private companies with stockholders and profits, they’re essentially government-sponsored institutions, established by federal law, which means they receive special privileges. Hmmm. Private companies, federally sponsored, with special privileges. Do I hear the word socialism creeping in? Well, yes, to a degree. Ostensibly if both Fannie and Freddie do well (i.e. make a profit) their investors will reap the rewards; if they are threatened with failure, the federal government will bail them out. It’s the ultimate quagmire for the free-market wingnuts to go absolutely batty over.

So what do these wingnuts do? Basically blame the two institutions that couldn’t have been more blameless for this calamity and insinuate that the mortgage crisis would never have happened if people who couldn’t afford the homes they were buying – yes, you guessed it, the poor – had simply not gotten into the market in the first place. Never mind predator lending; never mind a lack of government oversight. Let’s blame those who have the least. The ultimate class warfare. I guess we do have income redistribution in this country after all. Unfortunately it’s going in the wrong direction.

So you see some myths die harder than others, while some simply refuse to die at all. It’s like that sometimes when you’re dealing with people who live in Fantasy Land.

1 comment:

thrasybulus said...

Peter --

I hate to have to leave this as a public comment, but I haven't been able to find a way to send a private message to your site.

I have a blog of the same name which predates yours by several months, at www.conscienceofaprogressive.com. I chose the name as a riff on Goldwater's book "Conscience of a Conservative" and Krugman's blog "Conscience of a Liberal". Before doing so I researched on the 'net to make sure that I wasn't going to steal anybody's thunder, and I'm a bit uncomfortable that you didn't do the same (I assume you didn't...I can't imagine that you intended to infringe on another person's identity).

I'm sure that it was an honest mistake, and I feel terrible that I only found your site after you've obviously done a lot of work on it. But if you'll look you'll see that I do indeed have a prior claim. So I'd like to ask that you consider a different name for your blog. I've done a lot of work to establish myself and I'm sure you'd feel the same way as I do were you in my shoes.

If you wish to get in touch you can go to my site and there's a place at the bottom of the 'about conscience of a progressive' page that will send me a private message.

Thank you in advance for understanding, and as I said I'm terribly sorry to have to ask you to do this.