Eliminating the risk to taxpayers: privatizing Fannie Mae and Freddie Mac.

• Author: Boyle, Elyse
• Position: NOTES

"The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied." (1)

1. Introduction

   Economic turmoil can yield greater government regulation and oversight. (2) The Securities Exchange Act of 1934 followed the Great Depression. (3) The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 followed the savings and loan crisis. (4) The Sarbanes-Oxley Act of 2002 followed the collapse of Enron and WorldCom. (5) Congress recently passed the Emergency Economic Stabilization Act of 2008 in reaction to the mortgage meltdown and credit crunch. (6) The United States financial market has suffered major setbacks in the past few years and will likely face further economic downturns going forward. (7)

   The federal government must therefore devise solutions to the problems developing in the current financial climate. (8) Ineffective federal policies contributed to the current problems because they created moral hazards, especially in the mortgage industry, where both lenders and borrowers ignored the broader consequences of their actions. (9) Another contributor to the crisis was the securitization of real estate debt by the financial industry, resulting in complex and sophisticated products. (10) While some of these new financial products may serve valuable purposes, many have proven difficult to regulate and have contributed to the economic downturn. (11)

   This Note will discuss the uncontrollable growth of the mortgage giants, Fannie Mae and Freddie Mac, and the need to change the policies that created perverse incentives for financial institutions and investors to act in ways adverse to economic stability. (12) The first part of this Note will discuss the history of the federal government's role in financing mortgages and promoting homeownership. (13) Secondly, the Note will examine the secondary mortgage market and the innovative financial securities that have emerged in the past few years and the concerns that come with these new products. (14) Finally, part three of the Note will present arguments for privatizing Fannie Mae and Freddie Mac. (15)

2. History

   The current economic crisis originated in the real estate market, which experienced unprecedented failures in both the residential and commercial markets. (16) The root cause of these failures was a combination of easy credit, weak loan application standards, and lax governmental oversight. (17) The rapid growth of opaque financial products also contributed to the real estate market failures and accelerated the downfall of the overall financial industry. (18)

   1. Development of the Mortgage Market

      Prior to 1938, local banks were the primary source of residential mortgage lending. (19) The first time the federal government intervened in the private housing market was during the Great Depression to facilitate a stable mortgage market. (20) To support its goal of increased home loans and homeownership, Congress enacted banking legislation to restore depositor confidence and to encourage citizens to keep their money in banks. (21) Following banking reform laws, Congress passed the National Housing Act of 1934, which established the Federal Housing Administration (FHA) and created a mortgage insurance system. (22)

      The creation of a uniform, federally-insured mortgage instrument decreased risk for lenders, but a national market did not develop immediately because banks were uncomfortable underwriting mortgages outside their local geographic area as they were not familiar with market characteristics. (23) In 1938, President Franklin D. Roosevelt and Congress addressed this problem by chartering the Federal National Mortgage Association (Fannie Mae) as a federal agency to ensure a consistent mortgage credit supply throughout the country. (24) Initially, the federal government only authorized Fannie Mae to purchase mortgage loans insured by the FHA. (25) Specifically, Fannie Mae was to purchase FHA-insured mortgages from private lenders desiring more mortgage capital and then sell them to other lenders holding extra capital. (26) The private lenders were then able to use the sale proceeds to finance new mortgages and the process would repeat itself, thus constantly replenishing residential mortgage funds. (27)

      Congress created Fannie Mae to increase affordability and availability of homeownership for low and moderate income families. (28) Congress reorganized Fannie Mae in 1954 by removing federal backing for borrowings and allowing private capital in its place, thus creating a mixed ownership system. (29) By 1968 Fannie Mae had grown so large that Congress removed Fannie Mae's debt portfolio from the federal balance sheet and converted Fannie Mae into a government-sponsored enterprise (GSE). (30) Although converting Fannie Mae into a GSE allowed private investors to own and manage Fannie Mae, the United States Department of Housing and Urban Development (HUD) retained regulatory oversight. (31) The 1968 Charter also expanded Fannie's authority to buy non FHA-insured mortgages. (32)

      Two years after Fannie Mae became a private company, Congress chartered the Federal Home Loan Mortgage Corporation (Freddie Mac) as a stockholder owned corporation subject to HUD oversight to purchase conventional residential mortgages and to "provide liquidity, stability, and affordability to [the] housing market." (33) The stated purposes of Freddie Mac paralleled those of Fannie Mae: to provide a low-cost flow of mortgage capital, to link global capital markets to the United States mortgage market in order to make mortgage funds available for Americans, and to organize a secondary mortgage market. (34)

      Congress debated creating a new regulator for Fannie Mae and Freddie Mac in 1992. (35) While one side argued these institutions served a public purpose by lowering mortgage prices and did not need further regulation, the other rebutted that the firms had turned into money-making entities serving only stockholders' interests. (36) Congress eventually passed legislation establishing the Office of Federal Housing Enterprise Oversight (OFHEO), an independent agency within HUD, to regulate the "safety and soundness" of Fannie and Freddie, although Congress maintained control over the agency's budget. (37) OFHEO's mandate included implementing, monitoring, and enforcing capital standards. (38)

   2. Secondary Mortgage Market

      Congress created Fannie and Freddie to make mortgage financing available to homeowners by keeping interest rates low and by selling mortgage debt in the marketplace in the form of securities. (39) However, increased "securitization" of mortgage loans into financial products made it difficult for investors far removed from the underlying assets to accurately measure risk and value. (40) To understand the adverse effect securitization had on the financial marketplace in recent years, it is necessary to examine the primary and secondary mortgage markets, as well as the particular securities involved. (41)

      The primary market process begins when an individual seeking to buy a home applies for a mortgage from a primary mortgage lender, such as a bank, mortgage company, or a thrift, such as a savings and loan institution. (42) First, the lender determines whether the borrower meets its lending standards and has the ability to pay back the mortgage. (43) Following loan approval and the transfer of the funds to the property seller, the lender decides whether to keep the mortgage in its portfolio or to sell the mortgage in the secondary market. (44)

      Congress designed Fannie Mae and Freddie Mac to serve the secondary residential mortgage market by buying mortgages that meet their underwriting standards from primary market lenders across the county. (45) The primary lenders use the funds received from Fannie and Freddie to initiate more mortgages. (46) Fannie and Freddie bundle together their purchased mortgages into large groups to create securities, known as mortgage-backed securities (MBS), which they guarantee and sell to investors in public markets. (47) Fannie and Freddie repeat the process by using the resulting proceeds to buy more mortgages from primary lenders. (48)

      A mortgage-backed security is a security that represents an interest in a pool of loans, usually consisting of residential mortgages. (49) The lifecycle of a MBS through the primary and secondary mortgage markets is this: a homeowner sends his monthly payment to a lender or mortgage service that manages the payments, and then the primary lender keeps a portion as a fee for managing the borrowers' payment and passes the remainder of the monthly payment to Fannie Mae or Freddie Mac. (50) Fannie or Freddie passes the rest of the payments to investors who hold the mortgage securities. (51)

      In 1983, Freddie Mac began to issue collateralized mortgage obligations (CMOs), which create different classes of bonds backed by the same pool of mortgages. (52) Each class represents a different risk level and the classes are paid in order of ascending risk when principal and interest payments are received for the underlying mortgages. (53) Private investment firms became involved in issuing CMOs as demand for mortgage securities increased after the Federal Reserve's successive rate cuts began in 2001. (54)

      In 2006 and 2007, Fannie Mae and Freddie Mac lowered their standards for buying mortgages, thereby backing riskier mortgages, including subprime mortgages, to support HUD goals for increased homeownership. (55) By doing this, Fannie and Freddie took on more risk because they guaranteed payments to investors in the event of borrower default. (56)...