The Freddie &fannie

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THE FREDDIE & FANNIE ROPE TRICK

Ritesh Bhusari 8/4/2008

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THE FREDDIE & FANNIE ROPE TRICK Freddie Mac or the Federal Home Loan Mortgage Corporation and Fannie Mae or the Federal National Mortgage Association are US government sponsored enterprises (GSEs) and are two of the largest financial institutions in the United States. These two entities together guarantee or own roughly half of the $12 trillion US mortgage market. While they do not directly lend to homeowners, their role is to facilitate the availability of mortgage finance to homebuyers at affordable interest rates. They do this by buying investment quality mortgages from approved lenders and then packaging and selling these mortgages to investors. Mortgage lenders like commercial banks, savings institutions and credit unions use the proceeds from selling loans to Freddie Mac and Fannie Mae to replenish the pool of funds available for further lending to homebuyers. In effect, these institutions function as secondary market conduits between mortgage lenders and investors, thus expanding the scope of affordable housing in the US. Despite the fact that Freddie and Fannie are government sponsored enterprises, they are privately owned and enjoy special privileges like not having to register their securities with the government, not being liable to pay state and local income taxes, being conferred special treatment for investment purposes by bank regulators, etc. Being government sponsored enterprises, despite their private ownership, securities issued by Freddie and Fannie have the aura of a government guarantee and are priced as low-risk investments in the credit markets. As a result, they are able to place their securities at lower yields in the global financial markets than would have been otherwise possible, which in turn benefits US homeowners both in terms of access to credit and its affordability. This appears to be a neat and elegant capitalistic solution to the issue of augmenting home ownership where homeowners get easy access to affordable mortgages, lenders profit from originating mortgages without having to hold these mortgages in their books, investors earn a good return on their safe investment in securities backed by a pool of mortgage receivables guaranteed by government sponsored enterprises and Freddie and Fannie profit from their access to cheap credit. How then did the music in this never ending party stop? The fortunes of Freddie and Fannie were affected by the tremors of the subprime crisis though they were not packaging and selling subprime loans themselves. The mortgages Freddie and Fannie were buying were of investment quality with substantial down payments and meeting well-documented income criteria. However, with widespread repossession and distress sale of homes representing subprime mortgages, there has been a general decline in home prices leading to negative equity and delinquency in respect of several mortgages that met Freddie-Fannie investment criteria at the time of origination.

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Given the ease with which they could raise money from the financial markets because of their government sponsored enterprise status, Freddie and Fannie were terribly overleveraged with their owned funds backing an astronomical 65 times of debt and guarantees. At this level of leverage, it does not take much delinquency by the ultimate homeowners or adverse interest rate movements to bring the edifice crashing down and this was exactly the situation Freddie and Fannie were inexorably heading towards. The market called the bluff on the financial health of the GSE duo and “business as usual” became untenable for them. At the end of July 2008, the US government had to make the guarantees explicit by enacting a law that prevents Freddie and Fannie from collapsing and given the size of their obligations this warranted a substantial increase in the government debt ceiling to $10.6 trillion. The lessons to be learnt from this saga are many. For starters, there is a basic contradiction in terms in a privately owned entity that is also a government sponsored enterprise. A privately owned entity is subject to the discipline of the market place where lenders will carefully consider the financial health of the company and will limit exposure to prudent levels while doing business with the entity. It is the status of a GSE that helped create the aura of an implicit government guarantee — more so because this was not explicitly denied by the government, till recently — that allowed the GSE duo to go on a leveraging spree. Among the investors were several governments investing their foreign exchange reserves and this was certainly an additional factor forcing the US government’s hand in the bailing out of Freddie and Fannie. While the activities of Freddie and Fannie greatly helped the mortgage market and served a useful social purpose, the US government was in effect, keeping the enormous liabilities of the GSE duo out of its balance sheet. However, this did not make the US government’s liability any less or any less real. The private shareholders of Freddie and Fannie have been raking in supernormal profits over the years because of the special privileges granted by the government. There have been some attempts to break this cosy duopoly in the past but the powerful GSE duo had, like in many democracies, “managed” the political process very well through some deft lobbying. In the ultimate analysis, the strange animal that the GSE duo had evolved into represented the very pinnacle of misdirected incentives and rent seeking where private stockholders reap the benefits of special government dispensations but when the going gets tough, the tax payer is forced to pick the tab under the maxims “too big to fail” and “preserving the integrity of the financial system”. Of course, if there was ever a case for applying the “too big to fail” maxim this was indeed it, because the debt and guarantee obligations of the GSE duo was gigantic, nearing half the GDP of the US economy. What is surprising is that this level of indulgence to two shareholder-owned listed entities has not happened in a third-world banana republic but at the avowed temple of free market capitalism. In comparison, the dalliance of the Indian government with bailing out the infamous US-64 a decade ago appears to be kindergarten stuff! 3|P ag e

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