Fannie Mae, Freddie Mac: Were They Ever Broken?

The government has collected more than $20 billion in the past year from lenders who sold allegedly-subpar mortgages and related securities to Fannie  Mae and Freddie Mac, with more settlements likely to come.

When the Federal Housing Finance Agency (FHFA) announced in September that it would seek damages from a large assortment of major lenders a lot of people were unsure what would happen. But now, after a string of settlements including $9.3 billion from the Bank of America and $5.1 billion from JP Morgan Chase, it’s clear that FHFA — the federal agency which oversees Fannie Mae and Freddie Mac — did the right thing on behalf of the two giant government-sponsored enterprises.

That said, such huge financial victories raise a discomforting question: Why is it that Fannie and Freddie are still controlled by the federal government and not, say, Citigroup or the Bank of America?

The issue is certainly not just size — all the companies involved are enormous. The failure of one or more would have a profound (and awful) impact on the economy.

Nor is the question one of repayment, Fannie and Freddie have returned the $187 billion they received. Both Citigroup and repaid the $45 billion advanced to them by the federal government.

The government has given up all equity claims with Citigroup and the Bank of America but wants to keep Fannie and Freddie in its pocket, apparently forever. Indeed, according to The New York Times, a once-secret 2010 Treasury memo states that the government wants to ensure that “existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.”

Effectively, the government has seized two enormous businesses without compensation to shareholders, an event stockholders will no doubt claim violates the Fifth Amendment right to “just compensation” when private property is taken by government.

The whole matter concerning Fannie and Freddie reeks with oddities, starting with this one: Were the giant GSEs ever in danger of  failing?

$1.5 Trillion in Fannie Mae; Freddie Mac Assets
James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, said just weeks before the federal takeover that both companies were “adequately capitalized, holding capital well in excess of the OFHEO-directed requirement, which exceeds the statutory minimums. They have large liquidity portfolios, access to the debt market and over “$1.5 trillion in unpledged assets.”

It’s not unusual for companies to run into tough times and then borrow or use reserves to get past a rough patch. In the case of Fannie and Freddie their available assets dwarfed government advances by better than eight to one.

However, it’s not clear that Fannie and Freddie ever needed to borrow $187 billion in the first place. To understand why consider just the loss reserve at Fannie Mae: It went from $77 billion in 2011 to $47 billion in 2013. That’s $30 billion set aside at the direction of federal overseers, not money which was actually required to fend off creditor claims but an accounting shift which made the company’s position appear more dire.

Or, think about the $20 billion in allegedly-substandard loans that were passed off to Fannie Mae and Freddie Mac — money now being returned in the form of FHFA settlements. Would not Fannie Mae and Freddie Mac have seemed a lot more stable if they did not have to wait years to straighten out accounts?

Lower Home Prices, Higher Insurance Claims
As the value of residential real estate declined from the 2007 peak, claims against the insurance and guarantees provided by Fannie and Freddie increased. Here’s why:

If you have a home that has a $200,000 mortgage and the price rises from $210,000 to $250,000 there’s no foreclosure if the borrower can no longer afford the property. The home can be sold in the open market for enough to cover the debt.

However, if home values fall then the picture changes. A home worth $180,000 with a $200,000 mortgage is a big problem. Not only is the property worth $20,000 less than the debt, there are also other costs related to a foreclosure or short sale. The entities who insure or guarantee the loan in some way are all going to face a big loss, whether that third-party is the FHA, VA, private mortgage insurers or Fannie and Freddie.

The bottom line: The problems faced by Fannie and Freddie were caused in large measure by the loss of real estate values, losses set in motion by the failure of private lenders to properly underwrite loans and the widespread introduction of “nontraditional” loan products — what we today call toxic mortgages.

A variety of plans in Washington are now in place to dump Fannie and Freddie and replace them with new players from the private sector — but with  federal guarantees, just like the system in place today. Senate Bill 1217, the centerpiece of GSE “reform” legislation claims that if passed, “the full faith and credit of the United States is pledged to the payment of all amounts from the Mortgage Insurance Fund which may be required to be paid under any insurance provided under this title.”

In the end, trillions of dollars in assets and hundreds of billions of dollars in annual revenues will be awarded to the “winners” of the GSE replacement derby. But is this a derby which needs to be run?

Fannie and Freddie have never closed or even slowed operations during the worst of the mortgage meltdown. They function day in and day out, relentlessly, and at minimal cost to the public. Fannie, has enabled borrowers since 2009 to complete 12.3 million refinances, 3.7 million purchases, and financing for 2.2 million units of multifamily housing. During the same period, Freddie did 7.7  million refinances, originated 2 million purchase money mortgages and helped finance 1.6 million multifamily units.

Given such success what is the point of replacing Fannie and Freddie? Will taxpayer guarantees end? Will mortgage costs decline?

Here’s one answer: A just-released study by the Federal Reserve Bank of New York found that the five largest banks had a cost-of-funds advantage of 41 basis points — .41 percent — when compared with smaller competitors.

Now ask yourself: Do you see much difference or any difference in the mortgage rates charged by major lenders when compared with smaller lenders? If borrowers and taxpayers are not getting the advantage of large-scale efficiencies with mortgage rates today then why is it in their interest to replace Fannie Mae and Freddie Mac?

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