July 19, 2018 | ° F

A glance at Fannie and Freddie

Anyone who has picked up a newspaper or glanced at a television in the past month can tell that we are in the middle of a financial crisis and that it has something to do with subprime lending and mortgages.

Let's start with a few definitions to lay the groundwork.  Subprime lending is the practice of lending to individuals who would not normally qualify as borrowers.  Typically this means the person is low-income, does not have proper collateral, or has a poor financial history.  This means that subprime borrowers have a higher risk of defaulting on their loans.

Between 2001 and 2007 there was a housing bubble in the United States.  A bubble of this sort is purely speculative and is driven by the belief that prices will keep on rising.  Can anyone even count the number of people who were on-the-side real-estate agents?  In 2006, approximately 1 in every 52 Californians was a licensed real-estate agent!

Bubbles tend to inflate and then, when they reach the limit of sustainability, they pop.  However, on the upward inflationary ride it seems as if everyone is magically a winner.  Eventually something will have to give, but nobody wants to be the one who pops the bubble. 

In order to keep the bubble going, demand must keep pace with supply.  If there are too many empty houses on the market, supply is high relative to demand and prices will fall.  The solution to this, other than scaling back construction of new homes, is to increase the demand for housing.  This can be done by increasing access to housing which is typically done through lending.

Lenders pursued predatory lending practices that often misled the borrower into thinking they could afford what they were buying.  These practices were based on the mistaken belief that home prices would never fall, perhaps due to claims made by Alan Greenspan, former Chairman of the Federal Reserve, stating that home prices would not decline.  If prices continued to rise, then even if subprime borrowers defaulted on their loans, the bank or financial holding company could still seize the property and come out ahead. 

When the housing bubble burst and prices began to fall, people were suddenly paying off mortgages that were worth more than their homes and they naturally defaulted on their loans.  This left the banks holding properties that were worth less than the value of the money they loaned.  However, it was not only banks that ended up stuck with so-called ‘toxic assets'.  Due to creative financial securitization, banks repackaged subprime mortgages into new financial derivatives.  Due to the way risk is assessed, these new derivatives were calculated to be significantly less risky than they actually were.  This allowed banks to sell these mortgage derivatives to financial holding companies at higher prices than were actually justified. 

There are two mortgage markets: the primary market and the secondary market.  The primary market is what most banks engage in; they lend money to individuals wishing to purchase or finance their homes.  The secondary market is the market for mortgage-based securities which are financial assets whose value is tied to mortgages.  A bank will sell these securities to a financial holding company to raise more capital so that it can make more loans, thus providing easy credit to would-be homeowners.

Much ado has been made about the role of the government-sponsored enterprises Fannie Mae and Freddie Mac in this crisis.  Government-sponsored enterprises are publicly chartered but privately owned.  They were created to enhance credit flows in secondary markets.  Critics have charged that Fannie and Freddie issued loans to low-income individuals who could not reasonably pay them back and thus contributed to the subprime crisis.  Quite simply, the facts do not support those allegations.

Fannie Mae and Freddie Mac do not even engage in the primary market but only in the secondary mortgage market.  This means that they do not loan money to individuals but they do purchase mortgage-based securities from the banks that do operate in the primary mortgage market.  It is true that Fannie Mae and Freddie Mac complied with the Community Reinvestment Act (CRA) of 1971.  Wikipedia states that the CRA is a federal law "designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods".  The CRA only affects institutions that receive FDIC insurance.

While Fannie Mae and Freddie Mac were encouraged to purchase low-income mortgage securities (often disguised as low-risk), they were only purchasing mortgages that had already been made by other firms.  In fact, due to their federal charter, Fannie Mae and Freddie Mac are subject to more stringent regulations than most private institutions which are state-chartered.  Most states do not have as tough regulations as the federal government.  Thus, most private institutions move their headquarters to a state that has few regulations or does not try too hard to enforce them.  Fannie Mae and Freddie Mae are only permitted to buy conforming securities that meet certain requirements.  Non-federally chartered institutions are allowed to buy any securities they wish.

Many claim that these regulations are burdensome and represent an unnecessary intrusion of government into the private sector.  Federal Reserve data shows that approximately 84% of the subprime mortgages made in 2006, which was the height of subprime lending, were made by private institutions and only 4% of these institutions were subject to CRA legislation, the alleged cause of this situation.  Further studies show that subprime mortgages that were not subject to CRA regulations were approximately five times more likely to default than those that did comply with CRA regulations, all other things being equal.  According to data from Inside Mortgage Finance, the share of subprime mortgage-based securities held by Fannie and Freddie dropped from 48% in 2004 to 24% in 2006.  The reason for this was their compliance with federal regulations that prohibited purchasing such risky securities.  The late Federal Reserve Governor Ed Gramlich wrote that only about one third of all CRA loans even qualified as subprime and that these loans had a significantly lower risk of default than non-CRA loans.

There are two lessons to be learned here.  The first is that regulation works and an obsession with de-regulation got us into this mess.  Institutions that worked within the confines of federal regulations tended to hold significantly less risk than state-chartered companies.  Due to their compliance with CRA rules, Fannie Mae and Freddie Mac decreased their market share of subprime mortgages in the years leading up to the peak of subprime lending.  Regulations prevented firms from taking on too much risk; the push to de-regulate the financial industry gave firms the opportunity to engage in questionable behavior.  This behavior had been previously found to be unacceptable, most recently in the 1980's during the Savings and Loan Crisis.  This is why legislation was enacted in the first place.  The second important lesson is that Fannie Mae and Freddie Mac did not cause this crisis.  Simply put, Fannie and Freddie did not loan any money to anyone.  They purchased securities from the companies that did make risky loans, and gave them the capital to continue their risky behavior.  To blame Fannie Mae and Freddie Mac for the poor decisions of others is at best disingenuous.  It ignores the role that private firms played in acting unwisely and is merely a smoke-screen for the same people who consistently lobby for de-regulation.

Alexander Draine is a Rutgers College senior majoring in economics.  His column, "Draine on Society," runs on alternate Tuesdays. 

Alexander Draine

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