Wednesday, October 22, 2008


What was behind the government bailout of Fannie Mae and Freddie Mac? It wasn’t because they were too big to fail. It was because they were too important to fail, which many pundits do not like to recognize. In fact, how quickly they begin to show a profit again, after approximately $40 billion in losses to date, will determine when real estate recovers as well.

Fannie Mae was established during the Great Depression—Freddie Mac in the 1960s—to keep the housing market afloat, just as they are doing today. They have bundled and sold approximately $4 trillion in mortgages to investors while holding $1 trillion in their own portfolio. Because of their stricter underwriting standards, their default rate is less than 2 percent, where it is more than 4 percent for all conventional loans.

Why did they grow so big? Because banks are inconstant lenders, as I highlighted in an earlier column of the same name. Banks will lend during the good times, but not when they are in trouble as now with the subprime debacle. This has always been so, beginning in the 1930s, but also in the early 1980s when interest rates rose so fast that many banks and S&Ls stopped originating mortgages altogether.

Banks today are in trouble because of their short-term memories, for one. A recent New York Times article pointed out how quickly banks and regulators forgot the lessons learned from the Long Term Capital Management (LTCM) bailout on 1998 that cost banks and taxpayers billions of dollars.

LTCM failed because of their reliance on credit derivatives, in a word. The Nobel prize-winners who set up its trading model had not programmed into their computers how hedging mechanisms such as derivatives could bring down whole markets, in part because they were unregulated. This is while Fed Chairman Greenspan went on record as opposing their regulation.

Fannie/Freddie’s business model—that of a Government Sponsored Enterprise (GSE)—is what got them into trouble, especially with conservatives. They are a private stock corporation with some preferred tax treatments in order to keep their cost of funds low. The preferred treatment (banks had tax benefits in holding their debt, for instance) was passed on to the mortgage holders with lower interest rates—usually one-quarter percent below jumbo rates.

But the fact that they also had stockholders and so had to show a profit irritated conservatives who believe in privatizing even essential government services. That jumbo rates have soared more than one percent above conforming rates is a testament to the success of the GSE model, and the broken jumbo mortgage market.

© Harlan Green 2008

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