The GSEs were once the cornerstones of American Homeownership. However, at last count, the CBO estimated that it would cost taxpayers $389 billion through 2019 to "bail out" Fannie Mae and Freddie Mac . How did this happen?
Was it poor management, inadequate board oversight, political pressures, declining real estate values? Or was it a combination of all these reasons and more?
First, a brief history of Fannie Mae and Freddie Mac...
The FHA Administrator chartered Fannie Mae on February 10, 1938. The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans that had been originated by private lenders. After World War II, Fannie Mae's authority was expanded to include VA-guaranteed home mortgages.
The original intentions of law makers were simple: Provide liquidity to the home lending market and provide homeowner opportunities for Americans.
Then in 1954, the Charter Act removed government backing for borrowings used to fund Fannie Mae's secondary market operations.
After that, the 1968 Charter Act split Fannie Mae into two parts: Ginnie Mae and a reconstituted Fannie Mae. Ginnie Mae would continue as a federal agency and Fannie Mae became a "government-sponsored private corporation".
The next development wasn't far behind....The Emergency Home Finance Act of 1970 created Freddie Mac and authorized it to create a secondary market for conventional mortgages. The new law also required the HUD Secretary to provide prior approval of Fannie Mae's "purchase" or "dealing in" conventional mortgages (later interpreted by HUD regulations in 1995 to require specific approval of new and different conventional "programs").
The Secondary Mortgage Market Enhancement Act of 1984 ("SMMEA") authorized Fannie Mae to purchase and deal in subordinate lien mortgages.
In 1989 the Financial Institutions Reform, Recovery, and Enforcement Act ("FIRREA") made regulation of Fannie Mae and Freddie Mac consistent by severing Freddie Mac's ties to the Federal Home Loan Bank System and creating an 18-member board of directors to run Freddie Mac, and subjected it to HUD oversight. At the same time the GAO and Treasury were instructed to conduct studies of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
These studies laid the foundation for comprehensive regulatory modernization for both Fannie Mae and Freddie Mac in 1992 when the Federal Housing Enterprises Financial Safety and Soundness Act ("FHEFSSA") of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. This legislation created the Office of Federal Housing Enterprise Oversight ("OFHEO") as a new regulatory office within HUD with the responsibility to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely."
Most recently, the Housing and Economic Recovery Act of 2008 ('HERA') strengthened governmental oversight of Fannie Mae and Freddie Mac by establishing the Federal Housing Finance Agency (FHFA), which replaced OFHEO and HUD as Fannie Mae's safety and soundness and mission regulator.
HERE is a more detailed recap of Fannie and Freddie's history.
Where might the GSEs may have gone wrong?
- Migrating from a government owned (FNMA) or bank owned (FHLMC) enterprise to a publically traded company. FNMA and FHLMC were a Government Sponsored Enterprise (GSEs) that had the implied guarantee of the federal government, but operated as a public company. Operating as a public company drove management to grow and earn consistent quarterly profits for shareholders. Not that this was bad, but were the corporate objectives, strategies and the corresponding risks aligned or in conflict with its original charter?
- Migrating from being a buyer of mortgages to providing guarantees on securities backed by mortgages: Originally, FNMA provided a mortgage take-out solution for banks and mortgage bankers that provided home loans to its customers. FNMA, as a government owned enterprise, provided much needed liquidity to the mortgage market during the depression. It was the genesis of the secondary mortgage market. FNMA was a large portfolio lender that bought FHA mortgages from banks and mortgage companies, using debt to finance its portfolio of loans. FHLMC was owned by the Federal Home Banks and bought mortgages from its member savings and loans. Liquidity was provided by the Federal Home Loan banks.
With the proliferation of mortgage backed securities in the 80s, the GSEs’ primary business evolved to providing guarantees on their securities. Like FHA, the guarantee fees were built into rate that was provided to borrowers and paid to the GSEs as payments were made. Because of the implied guarantee of the US Government, the GSE securities received a triple-A rating. Regardless of the underlying mortgages, securities with a GSE guarantee were considered almost equal in safety to US Treasuries.
As Wall Street started to buy and securitize mortgages based on risk based pricing models, credit underwriting standards and criteria deteriorated. Stated income, no doc, NINA, limited do, appraisal waivers, etc, etc became the product of choice for mortgage originators and investors. As the GSE’s management began to worry about market share and profits, they began buying and securitizing these products as well. Private interest and social missions met at a crossroads and private interest priorities overlapped the GSEs's core business models.
When you combine faulty credit standards and declining real estate values...the GSE had entered the perfect storm. As we all got caught up in the commotion, so too did FNMA and FHLMC. However, I would say this: If all your friends are jumping off the Golden Gate Bridge, does that mean it must be ok for you to do the same?
Some might argue the decision to provide guarantees on securities was aligned with the original charters of Fannie and Freddie. I agree it did provide the mechanism to increase liquidity in the conforming secondary mortgage market. However, was management accumulating reserves in preparation for an unexpected "worst-case" scenario event?
