We've talked about mortgages and the mortgage crisis, and the challenges of the American real estate industry on this program for eight years now — almost as long as we've been talking about when the Federal Reserve might raise interest rates.
But you can't talk about mortgages in this country without talking about the two elephants in the room: Fannie Mae and Freddie Mac. They're behind an overwhelming percentage of all the home loans we get, and — since the dark early days of the financial crisis — they're publicly owned.
Fannie and Freddie are the subject of a new book by Bethany McLean called "Shaky Ground: The Strange Saga of the U.S. Mortgage Giants."
Here's a bit of our conversation with McLean:
A quick primer on Fannie Mae and Freddie Mac:
So they are part of the mysterious machinery that is an important component of most Americans lives, but you actually never think about it until things go wrong. What they do is, they buy mortgages from the institutions like banks who make them, and then they package them up into securities and sell them onto investors. And without the presence of Fannie Mae and Freddie Mac to buy up those mortgages, it’s not clear that the original lenders would make the mortgages in the first place.
People have been saying for decades that we should get rid of them, but the financial crisis came and went and we didn't. Why?
So, yes, that was the wisdom most definitely after the financial crisis. I even wrote it in my last book that the silver lining in all of this was that we had a chance to re-think housing policy, and we didn’t. Seven years later, these two companies are still sitting in conservatorship. Arguably, the dependence on them is greater than it has ever been before, because it turned out that private capital doesn’t like asset classes like mortgages that have caused it problems. And in the wake of the financial crisis, no bank wanted to make a mortgage unless they could sell it to Fannie and Freddie. So we’ve been totally reliant on these two companies, but people seem utterly unable to change.
Hear more of our conversation with McLean above and read an excerpt from "Shaky Ground" below.
"If the housing market tanks, so does the stock market. No matter who you are, this is hugely impactful. And no one is talking about it. No one realizes it."
—Ryan Israel, partner at Pershing Square Capital Management
On a bitterly cold gray day in December 2014, there was a strangely large crowd at the United States Courthouse in Des Moines, Iowa, where Senior District Judge Robert Pratt was hearing arguments in Continental Western Insurance Company v. FHFA. The title gave few hints as to why the room, the goings-on of which rarely transcend local interest, would be packed close to standing-room-only, filled with representatives of the country's top investment firms, including a slew of New York hedge fund types, along with prominent Washington lawyers, including a George W. Bush-appointed former U.S. Attorney and a Department of Justice lawyer.
FHFA, often pronounced "FOO-fa," is the acronym for the Federal Housing Finance Agency. It's an obscure government regulator whose major business is overseeing Fannie Mae and Freddie Mac, the mortgage giants that guarantee the payments made by a broad swath of American homeowners, and which were taken over by the U.S. government during the financial crisis. Continental Western is an Iowa-based insurance company that coordinated its case with Fairholme Capital Management, the famous investment firm founded by Bruce Berkowitz. The case in the Iowa court is one of many that investors including Fairholme have brought against the government for the way it has handled Fannie and Freddie.
The government lawyers were sputtering with outrage about the nerve of the investors to bring a lawsuit at all. It's not just that investors are accusing the United States government of misdeeds, which in and of itself is obviously a pretty big deal. But on the surface, the lawsuits seem to fail to appreciate the stunning amount of money—$187 billion, or about six times the annual budget of the National Institutes of Health—that taxpayers have put into the rescue of Fannie and Freddie. And taxpayers still could have to contribute more. Said the FHFA's lawyer, "Your honor, even with that $187 billion already infused, at this very moment, Treasury . . . is on the hook to infuse another—if it is required—in excess of another $250 billion of taxpayer dollars, a quarter trillion dollars . . . all this federal money was put in and [the investors] want to avail themselves of that federal money."
A news service called the Capitol Forum described the Iowa case as a "match-up between the Obama Administration and hedge funds." And the legal battles over Fannie and Freddie's fate do pit the most powerful office in the land against some of the country's wealthiest investors. But overall, the lawsuits are about much more than one side's victory or loss. They have reverberations for all of us.
Fannie Mae and Freddie Mac—officially, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation—are critically important and very large entities, with assets in the trillions of dollars, that were created by Congress but for many years operated as something between a private business and a government agency. They are meant to serve the longstanding dream of the United States as a society of individual homeowners; they do this by buying up, packaging, and reselling in bulk millions of mortgages that ordinary Americans take out from financial institutions. They are part of the lives of almost every homeowner with a mortgage in this country, and they are meant to generate a sense among investors that home mortgages are safe, because Fannie and Freddie, which are sponsored by the government, stand behind them.
The United States was historically a pioneer, and an outlier in a global context, in putting into practice such democratic ideas as universal voting, universal public education, and nearly universal land or homeownership. In all these cases, American society's big reach also generates big controversies, and in the business of homeownership the controversies are both domestic policy battles—why do we need the government in our mortgage markets at all?—and potential international policy issues, because many billions of dollars of U.S. mortgage debt are owned by other governments that very much want to see it as a stable investment.
Most people who weren't paying close attention probably date the beginning of the global financial crisis at September 15, 2008, the day Lehman Brothers declared bankruptcy. But a few days earlier, on September 6, the U.S. Treasury put Fannie Mae and Freddie Mac into a status called conservatorship, a kind of government life-support system hooked up because the rapidly swooning mortgage markets had arguably put Fannie and Freddie in mortal peril, and their failure would have caused global economic chaos. The Treasury gave Fannie and Freddie an immediate $200 billion line of credit. September 6 is probably a better start date for the final cataclysmic period of the long-brewing financial crisis than September 15. And, seven years later, the big banks that the government rescued at the height of the crisis are back to relatively normal operations, if they survived. Fannie and Freddie are not—and that's a problem.
The lawsuits have their roots in the aftermath of the crisis. Fannie and Freddie are publicly traded companies, and remained so even after the government put them in conservatorship, although their stock prices declined to near zero. In the darkest days, when most people thought the two companies would lose hundreds of billions of dollars, some of the country's most famous investors made a very contrarian bet: They would buy Fannie and Freddie stocks cheap, and then make a fortune on that investment after the two companies began producing profits again. And the two companies are indeed very profitable today. As of spring 2015, they have paid $231 billion back to the U.S. Treasury, or over $40 billion more than they got from taxpayers. The problem is that Fannie and Freddie are still in conservatorship, and the government in 2012 changed the terms of the bailout and is now directing almost all their profits toward reduction of the federal deficit. The investors think the government has broken the law, and that's why they are suing.
In total, the lawsuits, if successful, could result in the payment of tens of billions of dollars for securities that originally cost pennies; Bloomberg called it "one of the biggest potential paydays in history." But some investors are after even more than that. What they want is a say, and a stake, in the ultimate fate of Fannie and Freddie—and that, in turn, will decide the future structure of the American housing market. Both Fannie and Freddie came into existence as part of a government effort to promote homeownership that is almost as old as this country. The notion that homeowners will make better, more responsible citizens and therefore will help create a more stable society has persisted over time and across the political spectrum, despite a lack of hard proof that it's true. Fannie, the older, bigger, and far more powerful of the two companies, was founded as a part of the New Deal. "The significance of a new housing program that could revive the economy was not lost on President Roosevelt," wrote Marriner Eccles, the chairman of the Federal Reserve under FDR and the ur-Keynesian before Keynes. "He knew that almost a third of the unemployed were to be found in the building trades. . . . [Housing] would act as the wheel within the wheel to move the whole economic engine." In the decades since, Eccles's words have only become more true.
Neither Fannie nor Freddie lends money directly to homebuyers. Instead, they buy mortgages that have been made by banks and other lenders. The original theory was that the ability to get cash—immediately—for existing loans freed up mortgage makers to go out and make more loans. Having a national purchaser of mortgages also evened out the flow of credit in this huge, diverse country—or, as the International Directory of Company Histories described Fannie Mae's purpose, "In this way a Boston banker could invest in Arizona mortgages while a local lender in Arizona was no longer limited in the number of loans he could make by the cash deposits of his customer."
Originally, Fannie and Freddie owned the mortgages they purchased. But over time, as the capital markets in this country evolved, Fannie and Freddie began to package up the mortgages they purchased, stamp them with a guarantee that Fannie and Freddie would pay the interest and principle on the mortgages if the homeowners couldn't, and sell them as securities to investors. In essence, Fannie and Freddie are insurers, and insurers who offered an apparently gold-plated guarantee. Even before the Treasury's takeover, everyone believed that if there were a problem, the federal government would stand behind its government-sponsored enterprises, or GSEs, although officially, everyone denied that that was true.
In large part because of their perceived safety as an investment, American mortgages became catnip to global investors. By the 1990s, it wasn't just Boston bankers investing in Arizona mortgages, but Chinese workers and their savings accounts enabling Americans in Kansas to buy homes. By the 2000s, foreign central banks and other foreign investors were financing over a trillion dollars of American mortgage debt via their ownership of GSE securities.
It was Hank Paulson, the former Goldman Sachs executive who served as Treasury Secretary from 2006 until January 20, 2009, who orchestrated the government takeover of Fannie and Freddie during the financial crisis. Something that he says "took his breath away" happened during the summer of 2008, when he was at the Beijing Olympics. As Paulson wrote in his memoir, On the Brink, he heard at that time that the Russians made a "top-level approach" to the Chinese "suggesting that they might together sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies." (Russia has denied this.) Although Paulson said the Chinese declined, heavy selling of Fannie and Freddie securities would have reverberated throughout the already shaky financial system. Because the holders of Fannie and Freddie debt believed that the U.S. would come to their rescue, if the government had instead allowed investors to suffer losses on Fannie and Freddie debt, one of the consequences might have been questions about the creditworthiness of the United States itself.
When they were taken over, Fannie and Freddie had a combined $5.3 trillion in outstanding debt, which, had it been put on the government's balance sheet, would have increased the public national debt by about 50 percent. Partly to avoid that, the government left 20.1 percent of Fannie's common stock, as well as other securities known as preferred shares, in the hands of investors. That decision led directly to the drama in the Iowa courtroom.
What almost everyone expected was that the GSEs would long ago have been consigned to the dustbin of history, so this should all have been moot. When Paulson took Fannie and Freddie over, he told President George W. Bush in a meeting at the Oval Office, and he later told the whole country at a press conference, that this was a "time out" that should be used to "permanently address the structural issues presented" by Fannie and Freddie, by which he meant their conflicting responsibilities to the mission of homeownership as well as to their bottom lines. Soon, the government, which had a longstanding love-hate relationship with the companies it had created, and a co-dependent one at that, would wind down and eventually abolish them. Why couldn't purely private companies perform most, if not all, of Fannie and Freddie's role of packaging up mortgages, just like Wall Street banks did in the run-up to the financial crisis? "This is an opportunity to get rid of institutions that shouldn't exist," said Paul Volcker, the revered former chairman of the Federal Reserve, in 2011. The official view is still that Fannie and Freddie shouldn't exist. President Obama said, in 2013, "I believe that our housing system should operate where there's a limited government role and private lending should be the backbone of the housing market."
But here we are in 2015, and Fannie and Freddie are more important than ever before. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which is supposed to reshape the financial sector and which President Obama signed into law in the summer of 2010, quite deliberately did not deal with Fannie and Freddie. Nothing has happened since then, either. Fannie and Freddie remain wards of the government. As longtime housing analyst Laurie Goodman wrote in a 2014 paper, "The current state of the GSEs can best be summed up in a single word: limbo."
Meanwhile, the mortgage market in the United States has effectively been nationalized. This is precisely the opposite of what President Obama said he wanted. According to Goodman, from 2008 to 2013, the government was the major source of credit for most people who got mortgages, and the only source of credit for less-than-pristine borrowers. Goodman calculates that the government share of the home mortgage market was in the range of 78 to 85 percent, with Fannie and Freddie making up most of that. Compare that to the 20 years before the financial crisis, during which roughly half of all mortgages were financed without backing from the federal government, according to the Congressional Budget Office.
Nor have Fannie and Freddie shrunk. By some measures, they have gotten bigger. They still have some $5 trillion of securities outstanding. Foreign investors still own an estimated 15 to 20 percent of GSE securities. And by one important measure, Fannie and Freddie are in more precarious shape than they were in the run-up to the crisis. Because the government is taking practically every penny of profit that the two companies generate to shrink the federal deficit, Fannie and Freddie have not been allowed to rebuild any capital, which could absorb losses in the event of another downturn in the housing market. (By contrast, the government has forced the other big financial institutions to hold more capital than they did before 2008.) "We are faced with running this business with really no cushion. It is a challenging situation for us," Fannie Mae CEO Timothy Mayopoulos said on a conference call in early 2015.
"It's very scary to us personally," says Ryan Israel, who works for Pershing Square, one of the hedge funds that's suing the government. "It's the last unsolved issue of the financial crisis, and the ramifications are enormous for everyone."