The Danger of Government Guarantees

[Porsche-O-Phile]

By Fred Thompson (not intended to be political, I just think he nails it dead-on-the-head):

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The Danger of Government Guarantees

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I’ll bet it came as a surprise to most folks that the financial stability of the world as we know it depends upon the survival of a couple of outfits called Fannie Mae and Freddie Mac. Yet that’s what the so-called experts are telling us. Moreover, we taxpayers are now being asked to guarantee Fannie and Freddie’s tab, one that could make the $124 billion S&L bailout of the late 1980s look cheap.

So how did we get stuck with this bill? Well, Congress wanted to “do something” about what it saw as a “housing problem.” To them that meant that they should create an even bigger problem.

So Congress passed laws that made it easier for hopeful home-buyers to buy houses … even when they couldn’t afford them. Then the Fed and other regulators helped, in the form of easy money and loose credit standards for mortgages.

Not surprisingly demand for houses grew, home prices rose, lenders financed additional questionable mortgages, fueling even higher prices and so on. You get the picture. This is called a bubble.

Then an amazing thing happened – apparently impossible to foresee. Home prices did not continue to rise forever! Home prices came down and easy money dried up, causing the above mentioned cycle to reverse. In other words, the bubble burst.

So you’d think the in-over-their-heads homebuyers and the mortgage bankers would take the hit, and the market would right itself. No reason for an international meltdown here, right?

Not so fast my friends. Years earlier Congress established Fannie and Freddie as purchasers of these mortgages, which they could bundle up, repackage and sell to investors, freeing up more mortgage money. As government creations tend to do, the two companies grew until they either owned or guaranteed about half the nation’s $12 trillion dollars in mortgages.

Fannie and Fred were “government sponsored enterprises” which means heads they win, tails you lose. If they make money stockholders, creditors and Fannie and Freddie employees – some making millions annually – get the benefit. But now that mortgages have hit the skids, with mounting losses, the taxpayers potentially face trillions in exposure. This is because there is an “implicit” (read “actual”) government guarantee of Fannie and Freddie’s obligations and both are now too big to be allowed to fail. This is called the “bailout phase,” which will probably lead to a bigger bubble in the future.

Lost in this immense, complex mess is the root problem most people are missing: the government is gradually becoming the guarantor of seemingly every important aspect of American secular life, creating incentives and bureaucracies that cause failure and invite fraud.

In Fan and Fred’s case, it was in no one’s interest to turn off the bubble machine. Just the opposite. The system induced borrowers to take on financial obligations they could not afford and lenders to lower lending standards. Fannie and Freddie went along because their managers’ compensation depended on the firms’ short term financial performance. And investors continued to buy complex security packages they didn’t understand, because the securities were viewed as government-backed.

Heavy campaign contributions by those benefiting from this scheme induced Members of Congress to avert their gaze from the ugly mess that was unfolding.

You’d think we’d have learned by now: when the backstop of the federal treasury makes it easier for politicians, lenders, borrowers, welfare recipients, government contractors, or anyone else, to serve their own self interest at the expense of the taxpayer, many will do just that.

That is why we continue to see self-dealing, moral lapses, outright fraud and lack of management and oversight in a wide array of programs and government-sponsored entities, from housing to Medicare, education and the Small Business Administration, all costing taxpayers billions, even trillions of dollars.

Our Founding Fathers knew more than a little bit about human nature. It is one reason why in the Constitution, the federal government was given certain delineated powers and no others. I hate to burst another bubble, but our government simply doesn’t have the authority or the capability to be the guarantor or insurer of our every need or desire. Isn’t it time we started sending that message loud and clear to the big enablers in Washington?

[Rick Lee]

I'm not sure it's spot on. What law did Congress pass that loosened mortgage guidelines? The fed. gov't. doesn't tell investors what kinds of mortgages they can underwrite or buy. Pretty sure the fed. gov't. had no role whatsoever is creating the NINA or NINJA loans. Fannie and Freddie don't lend money and never have. And their guidelines were far more conservative than anyone's in subprime. Fannie's and Freddie's problems stem from the drop in home values. Subprime certainly contributed to the bubble and the burst. But Fannie and Freddie didn't throw money around recklessly. They should never have been allowed to get big enough that their failure threatens the whole U.S. housing market.

[dtw]

Don't have time to pick that article apart, but it has plenty of half-truths, omissions, and oversimplifications. Mostly true, but just slanted/colored enough to be fuel for the fire for those who are too dumb, too apathetic, or too committed to their own point of view to learn the specifics of this situation.

My favorite part is where he vilifies the stockholders. The stockholders got wiped out, a convenient omission from this article. Bottom line, the entities were too big.

Another fun line was talking about how the investors didn't understand the complex MBSs. Poppycock. FHLMC and FNMA are not Enron. Their securities are quite simple to anyone in a position to be buying them.

[Rick Lee]

Originally Posted by dtw

Bottom line, the entities were too big.

That's pretty much the crux of the matter. But when times are good, no one wanted to think about reining Fannie and Freddie in. IMHO, they should have been carved into about 10 smaller entities and not allowed to speak to each other. That would have kept them to a reasonable size and marketshare.

[legion]

I agree with the basic premise that government guarantees create a moral hazard.

I disagree that people were uninformed. The people at Fannie and Freddie, as well as the stockholders and people who bought the securities all thought they could make a buck before the $h!t hit the fan.

[HardDrive]

Come one, everyone who wasn't intentionally sticking their head in the sand knew damn well that when you throw out all the traditional requirements for getting a mortgage, really bad things are going to happen.

"We didn't know the securitys would be worthless."

Really? You don't watch CNN? You don't watch the stories about people who make $60,000 who 'own' 5 houses?

[Dan in Pasadena]

Move this to the political forum. I shouldn't have even read it and now that I have I have a comment to make but it shouldn't be here.

[Rick Lee]

Originally Posted by HardDrive

Come one, everyone who wasn't intentionally sticking their head in the sand knew damn well that when you throw out all the traditional requirements for getting a mortgage, really bad things are going to happen.

"We didn't know the securitys would be worthless."

Really? You don't watch CNN? You don't watch the stories about people who make $60,000 who 'own' 5 houses?

While that's true, Fannie and Freddie had nothing to do with those loans. Unfortunately though, they were affected by the home devaluations caused by such loans going bad.

[Porsche-O-Phile]

Not intended to be a political discussion (I thought it was interesting for the commentary regarding the economic situation and implications of regulatory failures and/or overregulation) but if it would be better in that "other" forum then move it there. Unfortunately I don't really visit that forum so I won't be commenting on it then or reading the responses, but whatever keeps the powers-that-be happy...

[Dan in Pasadena]

Jeff, I don't have any big monumental political OPINION to post; just a point of view on regulation and what i think the lack of it or the lax enforcement of it allows to occur. Given we are all human, in my opinion that makes us all subject to mistakes, lapses in judgment. But I just know others will have a different point of view, which on the old OT quickly caused blood to run in the streets! Frankly, I'm with you. I'm not going on that "other" forum if I can possibly avoid it...life is too short.

[dtw]

Originally Posted by HardDrive

Come one, everyone who wasn't intentionally sticking their head in the sand knew damn well that when you throw out all the traditional requirements for getting a mortgage, really bad things are going to happen.

"We didn't know the securitys would be worthless."

Really? You don't watch CNN? You don't watch the stories about people who make $60,000 who 'own' 5 houses?

If you can cite a case where someone making 60k held 5 conforming mortgages, then I'll send you 750 ml of your favorite distilled beverage.

Until then, it apparently bears repeating: FNMA and FHLMC have nothing to do with the subprime market.

Edit: As I do not feel this is a partisan political issue, I don't see any reason to move this. I don't really visit the new forum, and am enjoying the near-absence of certain 'contributors'.

[lendaddy]

Originally Posted by dtw

Until then, it apparently bears repeating: FNMA and FHLMC have nothing to do with the subprime market.

"Fannie Mae and Freddie Mac hold billions in subprime-backed securities"

http://www.iht.com/articles/2007/07/30/business/bxprime-web.php

[Rick Lee]

Originally Posted by lendaddy

"Fannie Mae and Freddie Mac hold billions in subprime-backed securities"

http://www.iht.com/articles/2007/07/30/business/bxprime-web.php

The article does not specify when that paper was bought. AFAIK, Fannie and Freddie never had any guidelines for underwriting subprime mortgages. Subprime is, by definition, the kind of credit bucket that could not go conventional or Alt A. However, the article does show that Fannie's and Freddie's subprime holdings seem to be performing pretty well. So my guess is that they bought up this stuff after subprime had ceased to exist as a loan origination vehicle. Contrary to popular belief, the vast majority of subprime mortgages are still performing just fine. The problem is that no one can get these loans anymore and that brought rising values to a screeching halt.

[lendaddy]

Originally Posted by Rick Lee

The article does not specify when that paper was bought. AFAIK, Fannie and Freddie never had any guidelines for underwriting subprime mortgages. Subprime is, by definition, the kind of credit bucket that could not go conventional or Alt A. However, the article does show that Fannie's and Freddie's subprime holdings seem to be performing pretty well. So my guess is that they bought up this stuff after subprime had ceased to exist as a loan origination vehicle. Contrary to popular belief, the vast majority of subprime mortgages are still performing just fine. The problem is that no one can get these loans anymore and that brought rising values to a screeching halt.

Well, it was at least prior to May of 2007 so I don't think it was after too recent.

[dtw]

Len - Rick beat me to it. Dead on.

Just curious - any $ value on their subprime holdings? Willing to bet they are immaterial.

[lendaddy]

Originally Posted by dtw

Len - Rick beat me to it. Dead on.

Just curious - any $ value on their subprime holdings? Willing to bet they are immaterial.

I'll do some research but let's remember you didn't think they had any at all. The article claimed 200 billion. Is that immaterial?

"The subprime mortgage bonds that Fannie Mae and Freddie Mac hold may have lost $4.7 billion in value, two Citigroup analysts, Brett Rose and Scott Peng, estimated in a report last week. The figures were based on reported holdings of $58 billion for Fannie Mae and $124 billion for Freddie Mac in December."

[lendaddy]

A CNCBC article I just read said Fannie and Freddie started gobbling up sub-prime between 2003 and 2006.

"By Reuters | 16 Aug 2007 | 10:55 AM ET
Font size:

Fannie Mae [FNM 0.5 -0.11 (-18.03%) ], the nation's largest source of home loan funding, increased its holdings of risky subprime loans in 2006 while its profits fell that year, the company said Thursday in a long-delayed report.

As the U.S. volume of higher-risk subprime loans increased from 2003 through mid-2006, Fannie Mae said its "purchase and securitization of loans that pose a higher credit risk ... also increased." It added that its holdings increased to a lesser degree than many other institutions. "

[dtw]

Originally Posted by lendaddy

I'll do some research but let's remember you didn't think they had any at all. The article claimed 200 billion. Is that immaterial?

"The subprime mortgage bonds that Fannie Mae and Freddie Mac hold may have lost $4.7 billion in value, two Citigroup analysts, Brett Rose and Scott Peng, estimated in a report last week. The figures were based on reported holdings of $58 billion for Fannie Mae and $124 billion for Freddie Mac in December."

$182 billion of a $5.3 trillion portfolio is immaterial, yes. Keep in mind, these entities trade hundreds of billions in securites every day. The scope of their size is often difficult to get your hands around.

Also, nowhere did I say they did not hold any subprime instruments. I said they had nothing to do with the crisis. A 'conforming mortgage' is one that meets the specifications promulgated by FHLMC/FNMA. Subprimes don't meet that standard (logically, there's a higher rate for the risk, if you don't qualify for FNMA/FHLMC backing - that goes right to their charter). If they hold subprime, then they likely bought them on the secondary market - but they are not, to my knowledge, a primary underwriter of those loans. Happy to eat my words if I'm wrong, though.

[dtw]

Originally Posted by lendaddy

A CNCBC article I just read said Fannie and Freddie started gobbling up sub-prime between 2003 and 2006.

"By Reuters | 16 Aug 2007 | 10:55 AM ET
Font size:

Fannie Mae [FNM 0.5 -0.11 (-18.03%) ], the nation's largest source of home loan funding, increased its holdings of risky subprime loans in 2006 while its profits fell that year, the company said Thursday in a long-delayed report.

As the U.S. volume of higher-risk subprime loans increased from 2003 through mid-2006, Fannie Mae said its "purchase and securitization of loans that pose a higher credit risk ... also increased." It added that its holdings increased to a lesser degree than many other institutions. "

Yes - the securitization of these loans by these agencies is a real pissoff. Despite being relatively insignificant/immaterial to their portfolio, it is still evidence of straying from their charter and completely irresponsible. They should not have gotten involved at all, even at this minute level. Their current problems are not related to subprime, however.

[lendaddy]

Does it really matter if they are the primary or secondary? If the primary market writes them because they know Fannie will buy them then isn't Fannie really the problem?

Also, I show that Fannie and Freddie have assets of about 800 billion each for a total of 1.6 trillion. Where did you get the 5.3 trillion figure?

182 billion is ~11% of the total holdings with my numbers. This is not insignificant.

Also, banks knowing they could wholesale them to Fannie/Freddie certainly would increase the number being written.