Monday, September 22, 2008
The Fannie & Freddie Bailout
When federal officials met with top Wall Street executives the weekend of September 13, they made one thing clear: The collapsing securities firm Lehman Brothers would not get the kind of taxpayer-backed bailout given to another Wall Street firm, Bear Stearns, just a few months earlier. That position forced Lehman into bankruptcy and drove another financial giant, Merrill Lynch, to sell itself to Bank of America at a fire-sale price. Which begs a question: If the federal government was now taking a hard line on bailouts, why did it step in only a week earlier to risk taxpayer money shoring up mortgage giants Fannie Mae and Freddie Mac? (The AIG bailout is a whole other question. See the related podcast.) Was this government takeover, potentially costing taxpayers up to $200 billion, the right move? What comes next?
Six current and former Wharton faculty members are nearly unanimous on one point: The government had no option but to keep Fannie and Freddie afloat. Mortgage-backed securities sold by the two firms are so widely held that to allow their prices to collapse would have caused a worldwide financial disaster. "I think they basically had no choice, because Fannie and Freddie are such huge players in the market," says Joseph E. Gyourko, chair of Wharton's real estate department. Wharton finance professor Jeremy J. Siegel agrees. "There are good reasons why Fannie and Freddie should never have existed, but given that they did exist and were a huge part of the bond market, there was absolutely no choice but to bail them out."
Opinions about the best way to rebuild the firms vary, but most of the faculty members feel they should have a smaller role in the mortgage markets than they currently have, and most believe they should be converted into privately held companies.
One issue at stake is whether U.S. homeowners should continue to have easy access to the standard 30-year, fixed-rate mortgage, with a set payment for the life of the loan. The alternative, dominant in the rest of the developed world, is the adjustable-rate mortgage, with payments moving up or down as prevailing interest rates change. "The federal government owes the taxpayer a hard look at these companies once the crisis has passed," says Wharton finance professor Richard Marston. "The Europeans don't have private corporations with government guarantees to buttress their housing markets."
No major change is likely anytime soon, the faculty members agree, since the U.S. housing market must first stabilize. That process could take years. In the meantime, the government takeover does call for each company to gradually reduce its holdings of mortgages and mortgage-backed securities.
Offspring of the Government
The federal government formed Fannie Mae -- the Federal National Mortgage Association -- in 1938 to provide mortgages, and it was a government agency until it was converted to a publicly traded company in 1968 to get its debts out of the federal budget during the Vietnam War. Freddie Mac -- the nearly identical Federal Home Loan Mortgage Corp. -- was created by Congress in 1970 and was a public corporation from the start, formed to give Fannie some competition. Recently, the firms owned or provided guarantees for about $6 trillion in mortgages -- about half the value of all home loans outstanding in the U.S.
The firms buy home loans issued by lenders such as banks and bundle them into mortgage-backed securities, a form of bond that is sold to investors. Instead of keeping a mortgage on its books for as long as 30 years, the mortgage lender thus converts its loans to cash which can fund more loans. Without this system, lenders must rely on savings accounts and other deposits for money to lend, and lenders are reluctant to issue the most desirable form of loan, the fixed-rate mortgage, because as conditions change, lenders could end up paying more interest to depositors than they get from mortgage borrowers.
To make the mortgage-backed securities more attractive to investors, Fannie and Freddie provide a guarantee: If a homeowner stops making monthly payments, the firm will pay them. When Fannie was a government agency, this promise was backed by the federal government.
As private companies, Fannie and Freddie have not had a legal right to such backing, but investors believed that because the government had created these "government-sponsored entities" it would step in to bail them out in a crisis. This implicit government backing made the firms' securities appear very safe, so investors settled for lower interest payments than they would otherwise demand -- a savings for Fannie and Freddie that reduced the mortgage rates paid by ordinary Americans.
Subprime Loans Take a Toll
As part of their dual role of making low-cost mortgages available and seeking profits for Fannie and Freddie shareholders, the firms also were allowed to operate as investors, borrowing money to buy mortgages or mortgage-backed securities issued by other firms. Amidst the ballooning subprime mortgage crisis in 2007 and 2008, growing numbers of homeowners defaulted on their payments, causing Fannie and Freddie to suffer multi-billion dollar losses. At the same time, the firms' investments in loans and mortgage-backed securities issued by other firms plummeted in value. The firms' share prices tumbled by more than 90% and investors around the world worried that Fannie and Freddie might not have the money to make good on their mortgage-security guarantees.
To calm investors, regulators took several steps in July to give the firms access to federal money, and Congress passed a law allowing the government to take the companies over if necessary. But the firms' share prices continued to fall, and the companies announced huge losses. On September 7, the Federal Housing Finance Agency announced it was using the July law to take over the firms, putting them into conservatorship, firing their top executives and making the implicit promise of taxpayer backing explicit.
There was no alternative, says Wharton real estate professor Susan M. Wachter. "Without this rescue, we would have had a far larger rescue on our hands," she says. "The banking system would have had to be rescued." The subprime crisis has driven many private mortgage lenders out of business, and caused others to limit lending. As a result, Wachter says, Fannie and Freddie are now responsible for upwards of 70% of all new mortgage loans. "Without Fannie and Freddie actively supporting the provision of mortgage finance, it's not too strong to say there would not be any mortgage finance," she says, adding that this would make home prices fall even further than they have.
Wharton finance professor Franklin Allen also supports the takeover, but thinks a quicker response could have averted some of the market turmoil that followed. "I think they had no real option.... It's a pity they didn't do it back when they first announced all these measures a few months ago," he says.
On the other hand, emeritus finance professor Jack Guttentag suggests the July moves were good enough to assure the markets that the government was willing to bail the firms out, making the takeover unnecessary. In fact, Treasury Secretary Henry Paulson had agreed with this view at the time. "It appears as if all kinds of pressures were put on Paulson to do this by foreign investors," says Guttentag, citing the Chinese and others with vast holdings of Fannie and Freddie securities. Foreign investors apparently threatened to reduce those holdings, Guttentag said, adding that this was most likely a bluff, since dumping these bonds in large numbers would undermine the values of the ones those investors continued to own.
Risks of Federal Control
Bringing Fannie and Freddie under federal control opens them to political pressure and raises questions about how their mission should change, according to Guttentag. "Very clearly, some new direction has to be established for these institutions, because right now they are in a kind of policy vacuum." Among the questions: should the firms relax lending standards to make it easier for people to get loans, even if doing so increases the risk to taxpayers? Should it enact a moratorium on home foreclosures, as some in Congress have demanded? That might help some homeowners but could also deepen losses the taxpayer would have to make up.
Like all government bailouts, this one sparks concerns about moral hazard -- creating a safety net that encourages more risky behavior. Wharton faculty say that while this is a legitimate concern, it was outweighed in this instance by the need to protect the financial markets. Moreover, the government minimized the moral hazard by declining to bail out Fannie and Freddie shareholders, which it could have done with an infusion of money. Instead, the shares are left virtually worthless. Even preferred shareholders will not receive dividends, and any future profits will go to the government to pay the 10% dividends on a new class of preferred shares the government received in return for the bailout.
"I think that was definitely the right decision," Siegel says.
For the sake of the markets, the government did protect Fannie and Freddie bondholders, and that may encourage some investors to lend money unwisely in the future, Gyourko says. But, he adds, "Remember, this is a quasi-public firm. So it's different from Bear Stearns, and it's different from Lehman.... There is moral hazard, but I'm less worried about it here than in those other cases."
All the faculty members interviewed expect the government conservatorship to last until housing prices have stopped falling and the market stabilizes, which they estimated will take until after 2009.
Guttentag sees three ways to reconfigure the two companies once the dust settles. One is to restore their quasi-governmental status, with taxpayer backing again implied but not guaranteed. "To me, that is a bad model," he says. "I've always been against the existing Fannie model because of its inherent ambiguity." An alternative, he suggests, would be to convert the firms to government agencies like the Federal Housing Administration, which emphasizes loans to people who have trouble getting them from private mortgage companies. While this would avoid the ambiguity of the traditional system, it would subject the country's largest mortgage providers to the kind of political pressure often directed at the FHA. Politicians, rather than market forces, would determine who is eligible for a mortgage, and whether some groups of borrowers should be favored or subsidized, he says.
The preferable outcome, Guttentag suggests, would be to completely eliminate the federal role and turn Fannie and Freddie into private companies. Since they would not have the advantage of implicit government backing, other companies could more easily compete with them, holding mortgage rates down, he argues.
Gyourko, too, favors privatization. The quasi-governmental system, because of the implied safety net, encouraged the firms' management to take unwise risks such as investing in mortgage securities backed by subprime loans, he notes. If Fannie and Freddie were privatized, he believes, their affordable-housing mission could be taken over by government agencies such as the Department of Housing and Urban Development.
Are Favored Lenders Needed?
Research suggests that privatizing the companies would cause mortgage rates to rise by no more than a quarter to one-half of a percentage point, Gyourko says, noting that other developed countries have healthy mortgage markets without government-backed firms like Fannie and Freddie. "Making loans is profitable. You don't need government to do this." Marston, too, says the firms should eventually be made private and cut off from government backing, but he acknowledges there is likely to be much opposition. "The next president is going to have to confront this Fannie-Freddie issue right away..... Just setting them up again like before would be irresponsible. But it is still likely."
While the problems at Fannie and Freddie did involve management mistakes, such as heavy investment in subprime mortgages, the companies' downward spiral would have happened anyway because the entire market was in trouble, Wachter argues. Lenders became too lax, requiring little proof that borrowers could afford their mortgages, and investors ignored the risks inherent in securities backed by subprime loans and other types of mortgages. "The Fannie and Freddie collapse would have happened even without Fannie and Freddie's own errors," she says. Therefore, she concludes, the troubles do not indicate the firms' quasi-public structure is flawed. Until recently, the system has worked well, she says.
In most of the world, homeowners are only offered adjustable-rate mortgages, with monthly payments fluctuating as interest rates change. Through Fannie and Freddie, fixed-rate loans have been widely available in the U.S. The fixed-rate mortgage, according to Wachter, "is very much a plus for the security and the stability of the American economy." She believes it deserves much of the credit for minimizing economic downturns between 1980 and 2000. Much of the recent turmoil has been caused by the collapse of securities tied to adjustable-rate loans.
Explicit government backing of Fannie's and Freddie's securities is now a fact of life and probably will continue to be, Wachter believes. Nonetheless, other changes should be considered, such as breaking the firms into numerous companies to better contain problems. She suggests that the real solution to the housing-related crisis is not to change Fannie and Freddie but to assure that loans are made only to borrowers who can repay them, and that investors better understand the risks inherent in mortgage-backed securities. "We need far greater oversight."
Wachter and her Wharton colleagues agree that in the wake of the Fannie and Freddie takeover, the biggest change for borrowers will be slightly higher interest rates and the return of the 10% to 20% down payment requirement, which reduces lenders' risks. Tougher lending standards have already swept the industry. "That's likely to persist," Wachter says, "and it's actually all to the good."