Objects Appear Very Far in the Rear View Mirror - Why We No Longer Need Fannie and Freddie

Firstly, I want to thank everyone for their comments and feedback. Many of you have pointed out other causal factors including: an indulgent or avaricious borrowing population and their lenders, short-term quarterly profit fixations of shareholders, credit rating agency negligence and accounting principles that are in need of a fix, amongst others. In the future I will try to address the accounting practices and how they affect the credit rating agencies who judge the value of the derivative or illiquid assets held by the financial institutions. However, someone asked a very good question that I think bears further examination. I was asked why I thought that a gradual winding down of Fannie and Freddie should be part of the solution.

Although there is clearly more than one cause to our current crisis, this question does go to the heart of the issue. In setting out my rationale, I will first start with a history of Fannie and Freddie, then move to a brief comparison of Fannie and Freddie to Ginnie, Fannie and Freddie's role in the growth of the mortgage-backed market and explain why I believe that their continued existence has an deflationary effect on the credit markets today by making credit artificially cheap - ironically, both what got us into this mess and why we need them to get us out.

I Never Thought I’d Say This…

It’s so difficult, just on a philosophical and gut level, for me to think back on the days of Reagan and Thatcher as a period of conservatism in the financial markets. I am shocked to be writing this. Ahh, the era of Glass-Steagall. The Glass-Steagall Act came out of the crash of 1928 and prevented investment banks (perceived to be riskier institutions) from owning depository banks (lower-risk institutions) in order to protect depositor's funds from being depleted in another meltdown. And there was a time, not too long ago, when investment bankers worked the long hours, took all the risks and either made it big or went broke. (Of course at the same time they made others very rich or pauperized more than a few of their clients.) Meanwhile, our commercial bankers at depository institutions wore suits several years out of fashion and could be found on the golf courses at 3pm on a weekday. They maybe had a bit of a better year if they attracted more deposits or took on a number of new mortgages or maintained a balance of cash flows between their fixed and floating rate debits and credits. They were risk averse and believed in a slower pace of growth.

In 1999 the US joined the rest of the financial world and let investment banks own deposit institutions, or what you think of as your typical bank. No other country in the world had such a distinction and new financial products were making the lines very blurry. The move to repeal Glass-Steagall crossed party lines and was passed with veto-proof support. (Not that Bill Clinton would have vetoed it anyway.) I remember watching the Senate vote on a tv in the lobby of the financial training institution where I worked. It passed 90 to 8. I still think that its repeal was a good idea. There were too many products crossing too many artificial lines; the regulators were stuck in jurisdictional morass, and given that nobody else had such a division, it seemed strangely artificial. One of the effects of Glass-Steagall’s repeal was to let investment banks participate in mortgage-backed security generation, which had previously been limited to depository institutions.

But, before we move on to the post-Glass-Steagall era, while we still think of deposit institutions like a Leave It To Beaver episode of politeness, risk aversion and a guy named Wally, let’s see what Fannie and Freddie looked like at the time. Fannie Mae was originally created to be a guarantor of government-issued mortgages. The US government has a need to be a guarantor of certain of our citizen’s mortgages. An example of mortgages that we might want the federal government to guarantee, might be the mortgages of the armed forces who from time to time may be called to service and not return or for returning veterans themselves. Fannie’s mission changed in the late 60s and this responsibility fell to the newly created Ginnie Mae, where it still rests today.

Fannie was to be a public-private hybrid, a “government sponsored entity” and, to keep it honest, we created Freddie Mac to compete with Fannie. Fannie and Freddie’s securities were no longer backed by the “full faith and credit” of the American government (as Ginnie's still are) but there was the general assumption that the government would bail them out if they became insolvent, which is what happened. As a government sponsored entity, Fannie and Freddie had to report to Congress and meet some Congressional demands, or possibly stand to lose their status. This status enabled Fannie and Freddie to save a fortune as the full risk of the instruments that they were creating wasn’t factored into the pricing of those instruments. And they are still partly private institutions with shares that trade openly with all the executive bonuses that attach thereto. They have a great interest in maintaining their ability to save billions by issuing discounted securities.

In a world of risk-averse, badly dressed, depository bankers, Fannie and Freddie helped to forward the policy goal of making home ownership easier for most Americans. Unlike today when deposit institutions create their own mortgage-backed securities, in the era of Glass-Steagall, this wasn’t happening to the degree that Congress wanted. To fill that need, Fannie and Freddie would come along, take the mortgages off the books of the deposit institutions, bundle them into mortgage-backed securities and sell them to the investment banks. This gave the deposit institutions free cash flow and helped to generate additional mortgage loans. Then the wall between deposit institutions and investment banks came down.

Most countries have a long history of the co-mingling of depository and investment banking cultures. Our modern history is less than 10 years old. And in that time we’ve managed to make a complete hash of it. Whatever endogenous risk-averse culture existed at large depository institutions was wiped away. Note though that credit institutions and independent or small regional banks have largely maintained this culture, some against a lot of pressure to do otherwise. Particularly at the large depository institutions, whether out of shareholder pressure, acquisition by an investment bank, pressure to increase share price to avoid a takeover, reveling in the fruits of new profits, or out of a sense of wonderment at the sheer novelty of it all, our stalwarts of bad dress and 3pm tee times began to dress better and work later.

Fannie and Freddie’s Search For Meaning

No other country in the world had a division like Glass-Steagall and no other country had government sponsored entities like Fannie and Freddie. In other countries, banks issue their own mortgage-backed securities and priced them based upon the risk-free rate and the perceived riskiness of the underlying assets in that bundle, also called a tranche. In a post-Glass Steagall world, depository institutions began to sell their highest creditworthy tranches directly. Fannie and Freddie, like any middle man, takes a cut of the action. By eliminating the middle man on the least risky securities, banks could sell directly and make more money. If they wanted to get their lower creditworthy loans off their books, banks could sell those to Fannie and Freddy.

Before Glass-Steagall was repealed there was never a year when more than $1 trillion dollars in mortgage-backed securities were issued by all issuers, private and government-sponsored entities. In 2003 we hit an all-time annual high with approximately $2.6 trillion issued, an increase of almost 300% in three years. This was a result of a number of factors coming together simultaneously: the cheap credit fostered by Greenspan’s monetary policies; changed risk tolerances in financial institutions; shareholder pressures; executive compensation packages that rewarded short-term profits; and the astronomical growth of the swap market where mortgage-backed securities are used as credit enhancers.

As I mentioned in my last post, where we hit a tipping point in this crisis, where we moved from a disaster to a complete fiasco, was in the use of leverage. Because mortgage-backed securities issued by Fannie and Freddie had the implicit backing of the US government they could carry credit ratings that didn’t accurately reflect their underlying risk. These riskier securities, which were mis-priced for their risk level, could be used to enhance the credit of other assets in a swap transaction. With a swap market of over $400 trillion, there was always a market for these credit enhancers, and Fannie and Freddie, desperate to remain relevant, were happy to provide them.

Facing increased competition in the higher creditworthy marketplace, and under intense pressure from Congress, Fannie and Freddie began to buy mortgages that were not just subprime, but were even riskier, they came without the usual documentation to verify borrowers incomes or savings. And these were turned around into mortgage-backed securities that still carried an A(ish)-class rating, on the low end of investment grade, but completely unrealistic given their risk properties. In 2007 alone, Fannie all by herself issued $79 billion of these securities. This is a classic moral hazard, where because of the perceived government backing, an instrument’s price lost all mooring from its risk and people perceiving high risk to be cheap engaged in even riskier activities.

Why I Think That Fannie and Freddie Need to Be Wound Down

Firstly, I think that with the repeal of Glass-Steagall, they’ve outlived their purpose. In hindsight, we should have wound them down when we repealed Glass-Steagall, but that’s ancient history now. Mortgage-backed securities can be created by private institutions themselves and priced appropriately. There is a healthy marketplace for them that leads to the appropriate pricing. We don’t need to insure these obligations.

I think that a strong case could be made for the continued existence of Ginnie Mae. We do want to promote, through cheap credit and artificially reduced risk, the home ownership of those who serve in the armed forces or returning veterans (along with a few other protected classes that fit into Ginnie's presently well-defined remit). I don’t think that our general service armed forces are paid enough for what they do. So as an additional compensation, making home ownership cheaper and easier seems fair to me. But if there ever comes a day where they’re compensated at a significantly higher rate, maybe Ginnie should go away too.

Ironically, right now we need Fannie and Freddie to buy distressed mortgage-backed securities back from the marketplace as no one trusts these assets anymore. They should perform their one last good deed, take the existing distressed mortgage-backed securities off the market, wait a while and then sell them back or eat the losses. But looking forward, there is enough that the government can do to incent home ownership through the tax code and other methods than to provide artificially high investment grade securities to investment banks on the cheap. I want my depository institution banker in tartan slacks, at his early afternoon tee time, with the leverage ratios, risk tolerance and culture of "only buy what you can afford" back. And we can't get there by having the government underwrite derivative instruments so that more people can live in bigger homes. Without the discount that Fannie and Freddie provide, some people who couldn't have mortgages in the first place wouldn't have their homes, true. And it also might force some people to buy smaller homes in more dense communities rather than McMansions in the exurbs. But these may turn out to be salutary effects, and I welcome a period where we see what happens in Fannie and Freddie's absence.