Fannie & Freddie

Background: The Federal National Mortgage Assoc (Fannie) and the Federal Home Mortgage Corporation (Freddie) were created as conduits between the home buyer (borrower) and a greater pool of funds than just the immediate lender could supply. Roosevelt birthed Fannie as a pure government agency in 1938 to spark the depression era home market. Johnson privatized Fannie in 1968 to get it off the books; Freddie was created two years later, also off the books. It was understood that these two were not a direct US credit but had "drawing rights", an opaque near guarantee.

Business types, shareholders and politicians working together through Fannie and Freddie naturally exploited public backing. Both became a profit center in their own right and as part of that, the past few years accumulated sub-par mortgages on speculation. Bad behavior was encouraged by Congress because the mortgage giants returned some of their profits directly as campaign funds or as "contributions" to favored constituents.

Democrat Barney Frank, chairman of the House Financial Services Committee, could be called the patron saint of these two. From the WSJ : "He encouraged the companies to guarantee more ‘affordable’ mortgages, thus abetting their disastrous plunge into subprime and Alt-A loans. He also pushed for, and got, an increase in the conforming-loan limits to allow Fan and Fred to securitize and guarantee larger mortgages. And he pressured regulators to ease up on their capital requirements -- which now means taxpayers will have to make up that capital shortfall."

The chartered purpose of both Fannie and Freddie is simply to buy loans from original lenders, take on the mortgage default risk, place a guarantee on that paper and then package it and sell it to institutional buyers. But because both took unnecessary risks it left them in bad shape for doing their real job. All the while Bernanke assured us there was no problem, telling Congress a few months ago that Fannie and Freddie were "adequately capitalized" and in "no danger of failing". Not quite. Both were insolvent, or close to it with an absurdly slender capital cushion given their exposure - perhaps roughly half the US market, that is, they hold or back more than $5trillion in mortgages.

Treasury Secretary Paulson sought powers in July to mount a rescue operation. Paulson was motivated by pressure from China, other sovereigns and central banks which had bought Fannie and Freddie debt by the truck load because the interest was higher than the rock low interest on direct US debt. These folks suddenly found themselves massively exposed. Thus, Paulson pulled the trigger Sep/6, taking control of both, firing incompetents, suspending dividends. The Treasury, all of us, own almost 80% of their stock.

Implications: As Alaska Governor Palin noted over the weekend, both now represent a substantial burden to taxpayers. The Congressional Budget Office has already placed $25 billion of estimated costs for Fannie and Freddie over fiscal ‘09 and ‘10. The final price tag will run much higher. The WSJ puts the figure at $200 billion. Our friend Bill Poole (former St Louis Fed Pres) reckons taxpayer losses will approach $300 billion.

Robert Craven