"I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction." --Treasury Secretary Henry Paulson, September 7, 2008, explaining why the Treasury was placing Fannie Mae and Freddie Mac into conservatorship.
The media often refers to Fannie and Freddie as "mortgage giants." The Government-sponsored Enterprises (GSEs) are giants, alright. Together they guarantee timely payments of principal and interests on approximately $4.5 trillion of mortgages that they have purchased and pooled as investment securities. They hold nearly $1.7 trillion of these pooled mortgages on their own balance sheets. And yet they have been invisible giants. They don’t deal directly with the public and their function is far from readily obvious to most people. Even their own marketing speaks in generalities and platitudes about what they do. "At Fannie Mae, we exist to serve America’s housing market. We provide a critical source of liquidity, stability and affordability to America’s housing finance system. Every day, we work hard to bring customers and partners together across the industry." That’s interesting, but, for clarity, it’s not exactly, "We build cars that go fast and make you feel like a movie star."
Fannie Mae and Freddie Mac pay cash to buy mortgages from banks and other mortgage originators. The cash allows the originators to make more mortgages, because the simple truth is that banks don’t have anywhere near enough funds—that is, liquidity—to meet the demand for mortgages. Mortgage bankers don’t have any money at all; they do nothing but originate and sell immediately. The mortgages Fannie and Freddie buy are aggregated into bonds called "mortgage-backed securities" (MBS). They are sold to and traded by institutional investors in large and very liquid markets. Fannie and Freddie themselves raise the money to buy mortgages by issuing other bonds, which are also bought and sold in equally large and liquid markets by institutional investors; in fact, most of these investors buy both the MBS and the bonds to meet their own needs.
As (formerly) publicly-owned companies, Fannie Mae and Freddie Mac expected and intended their operations to be profitable. But they were created and imbued to serve a number of social purposes as well. First, by providing liquidity and standardizing documentation, terms and conditions, the GSEs have made mortgages more affordable and available for all Americans in all economic climates. Second, by placing ceilings on the size of mortgages they could buy, the GSEs brought homeownership within reach of low- and moderate-income Americans. And third, through an ongoing series of targeted programs, the GSEs give a boost to first-time homebuyers, minorities, and underserved communities.
It is telling that, in his public statement announcing the conservatorship, James Lockhart, Director of the GSEs’ new regulatory agency, said, "We will review the charitable activities." No one expressed any interest or concern in Enron’s charitable activities (which actually were considerable), or Countrywide’s or Bear Stearns’. But the GSE’s philanthropies are not peripheral; they are integral. Bloomberg News related the following anecdote from new Fannie Mae CEO, Herbert Allison’s first meeting with employees:
"A chief concern among Fannie employees on Sept. 8 was whether the company would still sponsor its Help the Homeless Walkathon, an annual event scheduled for Nov. 22 and anticipated to attract 12,000 participants in Washington.
Allison, who lives in New York and said he has been living out of a suitcase the past few weeks, assured the assembly the event would go ahead as planned, and that he would attend. ‘I may have to get someone to send me my sneakers,’ he said."
This is the "flawed" business model—an entanglement of profit motive and social purpose—that Secretary Paulson identified as the primary reason for taking over the GSEs. It is unfortunate that Paulson has yet to explain precisely how and why the model is flawed. The markets had certainly not reached that conclusion. Fannie Mae’s common stock had actually rallied from a low of $4.40/share on August 20 to $7.04/share on September 5. Mortgage rates were falling from a high of 6.63% in the week of July 24 to 6.15% the week of September 4, for a reason that had nothing to do with the GSEs. Lower oil prices have significantly reduced inflation concerns, causing the 10-year Treasury note yield, the benchmark for 30-year mortgage rates, to drop from 4.10% to 3.625%.
But, what’s done is done, at least for the time being. Secretary Paulson was very clear that a permanent solution to the GSE’s status is up to Congress:
"Because the GSEs are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market. There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes."
Congress seems among the least qualified bodies on earth to develop a business model, but that issue aside, we at ShoreBank have a fundamental quarrel with the notion that profitability and mission are incompatible. ShoreBank’s core belief is that we are profitable because of—not in spite of or alongside of—our triple bottom line. In the early years we thought there was an inherent tension between profit and mission. The great corporate "aha moment" came when we realized that the inseparability of profitability, community economic development, and environmental sustainability in our corporate culture is the key to our success and longevity.
From the outside it’s impossible to really know another company’s culture. But if mission and profitability are as intertwined in the cultures of Fannie and Freddie as they are at ShoreBank, separating them will be perilous. It should be obvious that the Treasury would not have committed virtually its full resources to keep Fannie and Freddie operating if it did not believe they are vital to the US financial system. As soon as the subprime mortgage crisis hit last year, virtually all non-GSE purchases and securitizing of mortgages came to a dead stop. Without Fannie and Freddie buying mortgages at the rate of $40 billion or so a month, the number of mortgages being made today would slow to a trickle. The United States would be in a depression. This is not an exaggeration. In consequence, the rehabilitation of Fannie Mae and Freddie Mac as self-sustaining entities of whatever sort will be essential. With the economy still in crisis, no proposals on how to accomplish this task have been made public. Secretary Paulson has promised that "in the weeks to come, I will describe my views on long-term reform." ShoreBankers should pay particular attention. In some ways, our own business model is not so different from Fannie’s and Freddie’s.