Some mistakes are so egregious and yet so uncorrectable that no one is willing to admit them. On Sunday September 7, 2008, US Treasury Secretary, Henry M. Paulson, made just such a mistake. He ordered Fannie Mae and Freddie Mac placed into “conservatorship,” an ambiguous category of quasi-receivership that still defies precise definition. To see why Paulson’ decision was so unwise, we’ll start by deconstructing a financial instrument that most people assume they understand perfectly well: the 30-year home mortgage.
For a simple loan of 360 equal monthly payments, the ordinary home mortgage is packed with deeper implications, which, for both households and those who lend to them, cut to the heart of what it means to own a home. The 30-year mortgage is a fairly new product; before the late 1960s, most home mortgages had terms of no more than 20 years. That might seem an unimportant distinction…until you do the math. During the first 10 years of the amortization of a 30-year mortgage, nearly 100% of the monthly payments go to pay interest. Virtually no equity is built up until the second decade. Since equity is ownership, the household with a mortgage has no greater financial ownership of its home after 10 years than it did on the day the family moved in. But it’s a two-way street. The lender has no greater security either. Why would any rational person, borrower or lender, enter into such a risky transaction?
There are two answers to this question, one financial and one psychological. From the end of World War II until early 2007, home values went more or less straight up, with only mild, short-lived, and usually localized dips. Borrowers and lenders could count on equity being built up through appreciation of the underlying asset, the home, even without the principal of the mortgage being reduced. The psychological reason is even more critical. People become intensely invested in their homes, even when they owe more on their mortgages than the home is worth on the open market. As long as they have sufficient income, homeowners will make their mortgage payments.
What is sufficient income? Practically no one works for the same employer for 30 years. Yet lenders have traditionally felt comfortable making mortgages to almost anyone with a decent bill-paying history as long as he or she has two years on their current job. The assumption is that a person who can hold a job for two years will manage to stay employed in the future. The fact that many borrowers have little if any savings to fall back on should they become unemployed has generally been glossed over in making the credit decision. Interestingly, the age of the borrower doesn’t matter, either; in fact, taking account of age is discriminatory. A 60-year old can as easily qualify for a mortgage as a 35-year old, though the former is considerably less likely to be employed 10 years on. That common sense observation didn’t matter. As long as the household could pay, they would. If their circumstances changed, the increased value of the property would bail out both borrower and lender. It was a game without risk.
Well, not quite. There was always the little matter of the money. Somebody has to pay real money to the former owner when a home is sold. Banks don’t want to give their money to the seller for several good reasons. First, they don’t have nearly enough money to fund the roughly $11 trillion of mortgage debt outstanding. Second, banks borrow money primarily in the form of short-term deposits. Funding long-term assets with short-term liabilities is a strategy for disaster when interest rates rise. And last, at some fundamental level, banks have not wanted to take the credit risk of all those mortgages that weren’t really building equity and that were based on an invariably rosy future.
Fortunately for them, banks don’t have to. They can sell their mortgages to Fannie Mae and Freddie Mac, who would guarantee them. The banks earn fees, Fannie and Freddie earn fees. The now-guaranteed mortgages are pooled into securities and sold to investors around the world, and the money is recycled. This formula made the 30-year mortgage viable. And since the 30-year mortgage is what makes our consumer-driven economy viable, it is not an exaggeration to say that Fannie and Freddie have been essential to the post-World War II American success story.
It all sounds a little fishy doesn’t it? Why should global investors trust Fannie and Freddie’s guarantees, even before they were seized by Secretary Paulson? The companies had relatively little capital and histories of accounting shenanigans. Fannie and Freddie both stated repeatedly and emphatically that their debt was not guaranteed by the US Treasury. This was quite literally true and all those sophisticated investors knew it. They also knew that it didn’t matter a bit. The Treasury had—and still has—no choice but to unequivocally stand behind every penny of Fannie and Freddie’s senior obligations. Fannie and Freddie guarantee $5.7 trillion of mortgages. US-chartered banks hold $1.2 trillion of Fannie Mae, Freddie Mac and Ginnie Mae securities. Central banks throughout the world hold trillions more. Fannie and Freddie epitomize the concept of too big to fail. The proof is in the pudding. Their senior debt and securitized mortgages still carry the AAA-rating from all credit rating agencies. The debt is highly liquid and is priced by the market just barely below Treasuries themselves. It is readily accepted by all government and private lenders as collateral. As far as the bond markets are concerned, it’s as if the conservatorship never happened, even though common and preferred shareholders were wiped out.
But it did happen. Fannie and Freddie were able to do their magic because nobody questioned them too hard. What mattered was not so much how it all worked, but simply that it did work, until September 7, 2008, that is. Secretary Paulson based his decision on “the inherent conflict and flawed business model” that Fannie and Freddie embodied. The model was a combination of making a profit while serving a social purpose: spreading home ownership broadly through American society. They had been fulfilling their missions very well for decades, but during the housing boom, they saw their volumes of business seriously eroded by private purchases and securitizations of mortgages that were below their credit standards. We all know what eventually happened to these subprime mortgages (current national delinquency rate, 27.2%), but at the time, Fannie and Freddie had no choice but to compete by lowering their own standards. Furthermore, they were being pushed by Congress to lend to less creditworthy low-income and first-time borrowers.
That’s all in the past. Today, Fannie and Freddie continue to buy and securitize mortgages and now they have no competition. The private securitization market seized up in the fall of 2007 and has not revived. For the last three years, there have been virtually no new private mortgage securitizations. Older deals in the secondary market, even those few still rated AAA, sell at a steep discount to pools guaranteed by Fannie and Freddie. Without Fannie and Freddie, and to a lesser extent, Ginnie, there simply would not be a mortgage market in the United States today.
Congress has been threatening to do something, anything, with or to Fannie and Freddie since Secretary Paulson punted the ball to them. Two years ago, he said, “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.” As yet, no one has decided any of these issues, and, systemic risk or not, Fannie and Freddie have continued, if not precisely in their pre-conservatorship form, then certainly in the same business.
Or rather, a narrower version of the same business. The financial writer, Joe Nocera notes in a recent New York Times article that neither Fannie nor Freddie will buy a mortgage if the borrower has a credit score lower than 620. Nocera comes to the obvious conclusion that since Fannie and Freddie are the mortgage market, no one with a score below 620 can get a mortgage, even though credit scoring is notoriously inexact and subject to error. And even when the scores are accurate, they don’t reflect people’s life circumstances. Anyone who has been unemployed for more than a few months is bound to have difficulty paying bills, which will show up in the credit score and making it harder for the person to get back on his feet. To make things worse, Fannie and Freddie have effectively redlined communities where home values have dropped too precipitously. They have also drastically increased the percentages of units that must be sold in a new condominium before they will buy mortgages in it.
The irony is that Fanny and Freddie are now blamed for the crisis of which they were among the victims. Perhaps the most grievous and unfair insult is their cost to that modern incarnation of the biblical Job, “The American Taxpayer.” Critics fail to point out that the American Taxpayer and the American Homeowner are one and the same. Whatever it costs to keep Fannie and Freddie alive comes out of the taxpayer’s right hand pocket goes back into the homeowner’s left hand pocket in the form of the availability of an inexpensive mortgage. And, since mortgage interest is tax-deductable, it’s hard to understand quite how the taxpayer is getting hosed.
Here’s the bottom line. Before September 7, 2008, we had a mortgage system that, while rickety and obscured by smoke and mirrors, worked. It worked not because of an effective business model but because everybody—investors, lenders, and borrowers—realized it was in their best interest for it to work. Then Henry Paulson said, “Look, the emperor has no clothes,” as if that were news instead of common knowledge. Paulson chose conservatorship for Fannie and Freddie because it meant the Treasury only owned 79.9% of the two companies. One tenth more and their assets and liabilities would have gone into the federal balance sheet. That would have meant the federal government was explicitly guaranteeing all $5 trillion of Fannie and Freddie’s securitized mortgages and other debt. And that would have meant that the federal government was guaranteeing both sides of the consumer’s balance sheet: her bank accounts through FDIC insurance and now her mortgage.
If we were really Big Boys, we’d say, “Sorry. We messed up. We’re going to try to put it back the way it was.” But we aren’t that big and, as someone said to me recently, “Fannie and Freddie have become the third rail of American politics.” Instead, we’re going to let Fannie and Freddie totter along. In the words of Wall Street Journal editorialist Brian M. Carney, Fannie and Freddie are “money-losing zombie financial companies in the bosom of the federal government.” Maybe that criticism would be fair if Carney had a solution, but he doesn’t and neither does any one else. I don’t know that there is a solution. Fannie Mae, the older of the two companies, was created during the Depression when the typical mortgage had a five-year term with all the principal due at the end. Maybe that’s what we’ll go back to, so that only those who don’t really need a mortgage can get one.