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Voters like lower taxes and lower interest rates, but it should be obvious now that these subsidies come at a significant cost
Don’t Blame the Bankers (Pt. 2)
Government Cheerleaders In The Mortgage Market
The mortgage lenders had an active enabler in the form of Fannie Mae and Freddie Mac, the so-called government sponsored entities (“GSE’s”) that purchase and guarantee home loans. A bit of history, Fannie Mae was set up by FDR and the congress following the great depression as a means of providing liquidity (loanable funds) to the mortgage market, which had dried up following the failure of much of the country’s banking system. Once created, governmental agencies hardly ever go away, and sure enough, Fannie Mae continued using federal funds to support the market for the next thirty years. In 1968, the agency was privatized and a sister company, Freddie Mac, was created to provide additional liquidity to the market and to compete with the newly privatized Fannie Mae.
How do they work? Fannie and Freddie use private funding to purchase conforming mortgages (loans that meet a certain criteria for size, down payment, loan to value, etc.). The mortgage lender books a profit on the sale of the loan and the credit risk is off its books. The bank can then turn around and make another loan with the same funds, that’s how the GSE’s provide liquidity to the market. Fannie and Freddie package the mortgages they buy into securities that they market to investors. At first glance, this system fits right in with a capitalist society, private companies playing a valued role in the mortgage market. The problem is Fannie and Freddie are not treated like other financial companies by the market or by regulators.
The GSE’s get a sweetheart deal from the regulators. They are not required to comply with capital requirements like other financial institutions, meaning they can legally take on more debt and more risk, which they often do. They are also exempt from all state and local taxes. Furthermore, Fannie and Freddie are exempt from SEC reporting requirements. Other public companies are required to submit timely financial statements to the public and make certain other disclosures under the law. The GSE’s do voluntarily issue financial statements, but they have a history of fraudulent reporting. In 2006, Fannie Mae admitted to overstating its earnings for years to the tune of $6.3 billion.
Although Fannie Mae and Freddie Mac are ostensibly private institutions, the market has long viewed their debts as carrying the implicit guarantee of the federal government. Evidence lies in the fact the GSE’s have been able to secure financing at lower rates than other private companies with similar risk profiles. Buyers of GSE securities require lower rates of return because they believe the mortgages are backstopped by the federal government (even though each security plainly states that they are not) should Fannie or Freddie go bankrupt. This cheaper financing means they can pay less for the mortgages they buy, which trickles down to the actual rates charged to homebuyers. So, a qualifying homebuyer will receive a lower rate from his lender for a conforming loan than for one that cannot be sold to the GSE’s.
The definition of a “conforming loan” has evolved over time often at the direction of congress. Politicians love to espouse the benefits of home ownership. Owning a home has long been considered an integral part of the American dream. Presidents Bill Clinton and George W. Bush supported the easing of conforming standards to allow riskier borrowers’ access to Fannie and Freddie funding. During the past decade, the GSE’s began buying adjustable rate mortgages and those issued to subprime borrowers. Fannie and Freddie purchased $500 billion worth of Alt-A mortgages issued to borrowers who were not required to provide proof of income.