Freddie, Fannie, Finis?

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Given the events of a decade ago, 2018 promises to be a year filled with reminiscence. Chroniclers will recall the signs of the gathering storm: falling U.S. house prices, rising mortgage defaults and spreading institutional failures. All of these led up to the crisis of September and October 2008, which nearly fractured the global financial system. I personally remember spending long, stressful hours at the Federal Reserve Bank of New York during that interval, trying desperately to arrest the negative spiral.

If someone had told us then that the global economy would start one of its strongest expansions soon thereafter, we’d surely have thought them foolish. But that is the outcome we have enjoyed. Key policy decisions, made under immense pressure with limited information, proved to be astonishingly effective.

Most of the programs established to restore stability closed long ago, but one major piece of unfinished business remains: Freddie Mac and Fannie Mae, the government-sponsored entities (GSEs) that support the U.S. mortgage markets, remain under federal conservatorship. Obligations of Freddie and Fannie are held in portfolios around the world; the Federal Reserve, in particular, owns $1.8 billion of their bonds. As the future of these agencies is debated in Washington, a wide array of stakeholders is paying close attention.

Residential construction is seen by many countries as a key economic sector, and promoting home ownership is a common economic aim. Fannie’s history dates to the wake of the Great Depression, when it was chartered to aid the flow of credit to the U.S. housing industry; Freddie followed in 1970 to further support the secondary mortgage market. But the GSEs did not come to prominence until the early 1980s, when investors developed a thirst for mortgage-backed securities (MBS).

Basic MBS are simple: mortgages are pooled together and sold to investors. Payments made by homeowners are passed through to the MBS owner. Freddie and Fannie provide a guarantee that bondholders will not lose principal, even if a homeowner defaults. This assurance was critical to the growth of the MBS market.

Freddie and Fannie had an unusual structure. They had publicly traded stock, which benefitted from the rapid growth of the companies. But the two agencies also had a backstop from the U.S. Treasury, which was taken by many as a guarantee against failure. To critics of the GSEs, this seemed a little one-sided: if times were good, shareholders would gain. But under duress, taxpayers were at risk for losses.

The companies and their congressional supporters deflected this criticism for many years. Even as Freddie and Fannie expanded their activities and their exposures, they were allowed to operate with very small capital cushions. This proved fatal when the bottom fell out of the U.S. housing market.