Fannie And Freddie Caused…What?

October 6, 2008

It has come to my attention lately that Fannie Mae, Freddie Mac, and programs designed to increase lending to lower and middle income homeowners are still one of the main scapegoats for the current financial crisis. It’s all over news sites and blogs, being used in political ads, and lots of people are buying it without taking the time to ask one simple question – how did Fannie and Freddie fail?

There is no doubt that the subprime loan industry grew out of control. Predatory lenders entered the market. Subprime loans that should never have been given were rampant. In 2006, the Wall Street Journal reported that 61% of subprime loans were given to people with high enough credit scores for prime loans. The reason for this is uncertain, and can be argued from many sides. One side insists that, thanks to policies instated under Carter and updated by Clinton, banks were encouraged to make these loans. Fannie and Freddie were encouraged by Housing and Urban Development to increase loans to lower income homeowners, even though they were riskier loans. Another side is that investors were increasingly entering the real estate market because profits were growing by leaps and bounds. And if you’re like me, you’ve been raised with the belief that the real estate market, since it deals in tangible assets that grow equity, is a safe market to invest in. But how do these arguments hold up?

First, let’s examine the “government regulations forced it” argument. The regulation (known as the CDA) people speak of was passed in 1977. It’s intent was to make banks enter into communities they currently would not lend to. Why they would not enter those communities is still debatable. The policy, however, is widely recognized, and was known as “redlining”. As both sides seem to be able to agree that redlining existed, and prevented residents of lower and middle income communities from being able to get the necessary financing to make home purchases, I’ll leave the “why” to open debate. I’ll leave the rest of the research on the CDA, and the ramifications of it, to the reader as well. It is evident, however, that the CDA did increase the number of loans given to people who might not be able to pay them back.

Next, let’s examine the “speculative investors inflated the market” argument. Since this one has fewer emotional issues surrounding it, it will be a little easier to examine here. It is well known that investment and second property purchases were increasing throughout 2005 and 2006. By 2007, the Wall Street Journal reported on the fall of these markets. Simple economic principles tell us that, when purchases (demand) are higher than available commodities (supply), prices go up. And it doesn’t take a social scientist to notice that “flipping” houses was the en vogue get rich quick market of the early part of this decade. There were entire television shows devoted to it, and any insomniac could not help but be inundated by infomercials selling us schemes on how to flip houses for profit. It stands to reason that increased demand would raise prices.

So, what does all this have to do with Fannie and Freddie? From what I can find…not much. Here’s the problem. Fannie Mae and Freddie Mac held a combined total of around $500 billion in loans. The problem here is…none of these were the subprime loans everyone is so busy screaming about. In fact, as has been pointed out in the NY Times, Fannie and Freddie were not allowed to give subprime loans. It’s part of their charter. Believe it or not, no one in our government was stupid enough to allow Fannie and Freddie to give this sort of high risk loan. Amazing, I know…but occasionally, our elected officials get something right. As it turns out, most of Fannie and Freddie’s loan holdings are what is known as Alt-A loans. Alt-A loans are given when an applicant doesn’t meet one of the criteria to get a Prime mortgage loan. For instance, small business owners are often times not able to provide the usual paystub as proof of income, even though they make enough to safely take out the loan they are applying for. Alt-A loans allow the loan officer to, after review of the application, grant these people a loan at a rate that is generally 1% above prime rate for the first two years, and then falls to prime rate if all payments have been made in good faith. Beyond even this, the rate of defaults on subprime loans is nowhere near high enough to bring about the downfall of Fannie and Freddie.

Conclusions? Fannie and Freddie didn’t fail because of subprime loans or risky lending to homeowners. They fell because of much larger market conditions surrounding the CDOs, Credit Swaps, and MBSs that I’ve already discussed in the “How We Got In This Basket” series of essays. As I didn’t want to make this post too link heavy, the sources for the numbers on Fannie and Freddie aren’t linked. If anyone would like to see them and is having trouble finding them, just let me know and I’ll post a list of sources here.


One comment

  1. Well done, son. If it were expanded on, making it about 25-30 pages, by including more of the facts you point to, and maybe working back another level or two in the references, it would probably be good enough to at least a Sr. term paper – maybe even a Masters thesis paper (though only at a lesser college, I suspect).

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