To be honest, this is a case where my opinion has changed as I learned more facts. When I got interested in who was collecting the Fannie/Freddie money, I googled it and the first link I hit was the OpenSecrets site that showed Dodd, Kerry, Obama, and Clinton at the top of the list, and 7 out of 10 being Democrats. Later on, I found the other site which has a more detailed breakdown, which showed that over the years Fannie and Freddie were essentially paying off both sides. I’ll bet the waters would get even murkier if you started looking at all the other various financial institutions that have supported Congress.
This is a case where a problem grew out of control because neither side in Congress has a vested interest in reigning it in, because their interests aligned. The Republicans like supporting economic growth, especially when a Republican is in the White House. And the Democrats like removing risk from the market, because the poorest people tend to also be the riskiest. How much have we heard about how unfair it is for ‘predatory lenders’ to charge higher rates for a low-income family of four than for some wealthy businessman? The answer is that the lower income family is a bigger risk for default, so their loan costs the bank more and they have to charge more. Get rid of the risk, and you even the playing field. And Democrats love even playing fields.
But I do have to single out Chris Dodd here. Not only was he the biggest recipient, but he’s the only one who seems to have taken an active interest in actually defeating legislation and in lobbying everyone from his fellow Senators to the President on behalf of Fannie and Freddie. And, it also turns out that he has a ‘Friends of Angelo’ loan at a special "just for my good political friends’ rate, from Countrywide Financial. He needs to be investigated.
Fannie Mae and Freddie Mac are certainly a large part of the story. But Sam overemphasizes them here.
Freakonomics extended a guest post to Doug Diamond and Anil Kashyap: The F.A.Q.’s of Lehman and A.I.G. is worth a read. Now true, Mae and Mac “…were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards.”
But if I understand this correctly there was a whole bunch of SIVs and multiple layered derivatives and the like that the Frankenstein twins wouldn’t touch. Yet, they still found a large pool of investors. Why?
I blame:
Agency problems. Mortgage originators could earn bonuses one year that they didn’t have to give back once the underlying loans ultimately turned sour. Ditto for the mutual fund managers who purchased those securities. The taxpayer is only one of the likely bagholders.
But I also blame the regulators for not tightening up bank lending standards. The late Ed Gramlich called for additional curbs earlier this decade, but Greenspan turned him down. And frankly, within a Republican administration, it was never going to fly: market fundamentalism was and is simply too heavily entrenched in the Republican party.
Sometimes market fundamentalism leads to boneheaded decisions, based upon pure crankery. But there are other cases where reasonable people can disagree. This was one of them. So yeah, I can imagine that a Democratic administration could have been asleep at the switch from 2002-2005. But I would think that they would have woken up sooner. After all, even Mae and Mac started to tighten standards in early 2007.
Just to be clear. Mac and Mae opposed additional supervision (what a surprise!). But mortgage originators already fell under existing regulatory authority. I can see no reason why no-documentation loans for example should have been permitted for more than say 6 months, before the regulators put a halt to the practice. A more interventionist government might have done so.
Cast your eye here. Rick Davis, McCain’s campaign manager and long term adviser, got $30K a month for five years as president of an advocacy group set up by Fannie Mae and Freddie Mac to defend them against stricter regulation.
This doesn’t make Dodd blameless, but just shows they spread their money around widely.
And it is all besides the point, which actually is that the GSEs were not the root cause of the debacle.
In 1995 GSEs (Government Sponsored Enterprises - or Mac and Mae) purchased and pooled 70% of all mortgages. By 2004 they accounted for less than 10% of new mortgages.
What was new were the boys on Wall St. running amok.
He is not the only conservative counseling a cautious approach to this bail out. William Kristol isn’t too pleased with this plan either:
The same guys that are saying we must act fast are the same guys that were telling us just a few months ago that the economy was fine, there wouldn’t be a recession and there was no disaster looming. Why should we believe them now?
This whole “if we don’t act immediately, the economy will implode” imperative is what raises red flags for me. It is the same thing Bush did to ram through the authorization to invade Iraq; inflate the risk and claim that our very survival depends on swift approval of his plan with no debate and no changes. Well, I’m not buying it. There is every reason to believe that this cure will cause more damage than letting these companies fail and taking our medicine for years of bad policy.
Yes I am giddy that for once both parties have finally shown up. Without a doubt I will become more politically active than ever before if this behemoth pile of horseshit passes. And try to vote out anyone that votes for it. Adding some extended unemployment, increased foodstamps, homeowner bailouts does not make the horseshit any sweeter. More oversight*, government getting equity stakes which was agreed too also doesn’t.
Without a complete overhaul, from regulation to independent oversight this mess will be here.
You want change you can believe in? Vote None Of The Above!
*They want oversight over the spending of the money, fox guarding henhouse anyone? Those in power are those that helped get us here.
No, they don’t. Collectively they bought up about 20% of mortgages the last couple years. If they had really had 90%, then the government would already own the vast majority of these crap loans and it wouldn’t be necessary to undergo a 700 billion dollar buyout. The buyout would’ve happened automatically with the US government assuming responsibility for the two companies.
And obviously, if F&F had actually soaked up so much of the market, then we wouldn’t be having this crisis with major company failures because the private finance firms would’ve been spared from buying all that bad juju since it had already been mostly taken off the market. Instead, though, the financial sector willingly ate down the other 80%, and now many of them have sunk from all that ballast. And in fact, Fannie and Freddie (under new management) have already been given permission to start buying up even more of these mortgage-backed securities as the beginning of the government bailout. Of course, they’re not going to eat the entire 80% of what’s left, but they’ll make a start on it.
Yes, these GSEs were the biggest single purchasers of this junk, but the rest of the market came to the same incorrect conclusions about the value of these securities. And then the market failed.
My understanding is that this is not the case at all: the securities based on sub-prime loans were purchased by private sector financial institutions all over the world.
Here is a Wikipedia list of sub-prime related write-downs and the two GSE’s are well down on the list:
Sam Stone’s post is a great starting point as to how GSEs distort markets and the inefficiency of government intrusion on the markets. However, his post doesn’t address everything.
The GSEs were fine until investors became more sophisticated, and they had started buying more stock and expecting more profits like a corporation. In the 1980’s FNM almost went out of business because of poor management of its assets and liabilities (as in low profit maximization). From what I’ve been reading, basically the cost of servicing its liabilities exceeded the income derived from its, at the time, relatively modest mortgage portfolio. This never should have happened given the ability of FNM (e.g. creation and bundling of derivatives, various interest rate swaps, the direct line to the treasury it has, etc.)
After surviving the 1980’s FNM became more sophisticated with its portfolio. The main instrument they used is the callable debt instrument (or security or bond, aka mortgage backed securities). Not utilized previously by FNM, these instruments allow FNM to issue securities (corporate bonds) backed by its assets (typical housing mortgage loans), such that the payout of the securities matched its assets. Otherwise, when rates dropped, homeowners would refinance and jeopardize the instruments which they backed. Since FNM issued its own callable debt instruments, they controlled when they would utilize the call option.
Normally, callable debt is expensive, more so than the mortgages that backed them (e.g. when interest rates drop homeowners would refinance, then the bonds (issued off the mortgages) get called). But, thanks to the inherent comparative advantages of FNM, FNM could issue these callable debt securities at yields only slightly higher than T-Bonds (normal government issued bonds), and its cost to refinance was also extremely low. Because of this, they could issue these callable debt instruments at a hefty, hefty spread (i.e. profit).
FNM also crowded out the market in traditional loans. Their access to cheap financing and backing by the government (i.e. its inherent advantages), meant that private banks had to take on more risk in order to compete, e.g. sub-prime loans.
With these advantages and market distortions/conditions, FNM could now make more money on mortgages that they bought, rather than on what they were paid to raise money in the markets. More succinctly, FNM’s original role was to buy mortgages from the market, package them up into securities/bonds/debt instruments/what have you, guarantee those instruments against loss, and then sell them to other financial institutions (hedge funds, banks, mutual funds, investment firms, etc.) As The Economist points out, this original function wasn’t really a problem (yet another bonus of government intervention) as the conforming loans they bought did just that, they conformed (and they still do so even now). With the callable debt instruments they issued off of it, they could prevent prepayment (i.e. FNM decides when to call because of its packaging ability), effectively making these instruments “risk free” (except for credit risk, which is still low because of their conforming guidelines).
However once FNM realized that they could buy those same securities for its own portfolio and lock-in “risk free” profits, FNM became a major buyer of its own securities. FNM was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default. FNM continued this strategy because 1) its holding requirements were lower, because, 2) ultimately, everyone believed that the US government would back them. According to The Economist article, this led to FNM having $83.2B to back $5.2T (that’s Trillion), a gearing ration of 65 to 1 (for perspective, though they are not typical homeowners, e.g. my income to mortgage payment represents ~33% of my net income, or ~.33 to 1)
Surprisingly, the problem came from there not being enough mortgage securities (essentially backed by conforming loans) for FNM to buy and thus increase its projected earnings growth. The easiest solution at the time was to increase the amount of loans that FNM could buy, but being a GSE, this had to be approved by Congress. This proved difficult because these “jumbo” loans were dominated by commercial and investment banks. To further its habit, FNM sought a different political approach under the guise of “increasing home ownership” and “affordability.” This probably led to the donation scandals and the Barney Frank opposition to regulatory reform that Sam mentions above. Regardless, one thing it did do, was make the terms “increasing home ownership” and “affordability” into code words for lax underwriting standards. (see also here and here) Politicians business people/the market alike liked this direction because politicians liked the way they could promote more home ownership and the market liked it because of the return they were getting from FNM and the increased costs in origination fees to start the loans that FNM would eventually buy. These lax underwriting standards again caused private banks to have to re-tool their lending practices in order to compete with FNM.
Well, according to Wikipedia: “As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.” I’ve seen higher estimates, and I’ve seen other calculations that resemble Sam’s 90% quote. Even at the super conservative 50%, because of the way FNM was leveraged, it’s enough to cause a lot of damage to the market. Also, because of the way it is leveraged, and because it did have conforming loans prior, the amount of the buyout doesn’t have to be a 1-to-1 ratio, because eventually some of the loans will pay out.
Since the FNMs were buying these things off themselves, and since they have government backing, the reason for the lack of default is because they are making the interest payment, rather than let the loan default.
Who originated the sub-prime loans often without adequate appraisals?
Who create securities based on sub-prime loans?
Who purchased the above securities?
My understanding is that in all three cases it was largely private-sector institutions which were responsible for creating the whole sub-prime market and the two GSE’s were mainly operating in the rest of the market. If that’s false I would appreciate a source.
This articlesays that the two GSE’s held around 170 billion in sub-prime bonds as of 2007 and this article puts the total value of sub-prime bonds at 1.3 trillion.
Now it’s not clear how comparable the two figures are and whether they are talking about face value or market value but still it doesn’t appear that the two GSE’s were dominant players in the sub-prime securities market. Again I would welcome any evidence to the contrary.
They may *all *be overvalued, even the ones with one hundred percent kosher and copacetic mortgages. House value has become wildly inflated, houses cannot be sold for their “value”. The property taxes based on that value are inflated. And nobody can get a mortgage even if the value were fair.
The problem is not the value of the CDOs. The problem is that no one knows the value of the CDOs. If the values were known, the banks could write them off. Some would fail from lack of capitalization, but the rest would get on with their lives. No one is doing anything now because they can’t tell how healthy their trading partners are. The cause for this is that the small percentage of subprimes with problems are buried CDOs so complicated that no one knows their real creditworthiness.
Which is a big problem with the bailout, since what will the government pay for these things?
Merrill, by the way, dumped a lot of their CDOs at what was considered a firesale price - but it cleaned up their books enough for them to get acquired. Lehman didn’t. There was an interesting article in the Times Sunday contrasting the two strategies, and how the Merrill CEO, relatively new, was able to admit that these were junk and get rid of them.
Alright, if we add the guarantees instead of just the actual mortgages owned by F&F (which was my literal interpretation of that post), it certainly does bump the number up from 20%. But 50% is still not “super conservative”. This is still some wiggle room under that number. This Bloomburg article suggests that 40% is the lower bound.
That ain’t chump change by any means, but it’s still plain that the rest of the financial markets agreed with F&F’s assessment of the value of these mortgage related shitpiles. It’s hard to make an argument of moral hazard distorting their perceptions when even the players who had no expectation at all of a US bail-out nevertheless priced these “assets” identically.
It shows our system of funding elections is flawed. Companies and lobbyists give to both sides to get their hooks in them. Elections are so expensive our politicians spend over half their time fund raising. It has got to stop.