In fact, I would make the thesis that Fannie and Freddie both acted in a much more nefarious way than the way the media has portrayed them. In fact, I believe that Fannie/Freddie's commitments to the CRA was minimal and trivial in the larger scheme of their entire portfolio. I am not even so convinced that their commitments to CRA did anything substantial to bolster ownership in underserved areas. Rather, I am of the opinion that these two mortgage giants used the CRA as a trojan horse in order to shield themselves from proper government oversight in order to engage in all sorts of risky behavior. The politicians, Democrats mostly like Barney Frank and Chris Dodd, decided to limit oversight as much as possible because they themselves were convinced that Fannie and Freddie were doing such a good job servicing underserved neighborhoods.
As such, Dodd, Frank et al resisted all Republican pressures to apply more oversight to these two giants. Both Fannie and Freddie are not like your average private company. Since they are Government Sponsored Entities, they receive special favor from the Federal government, like a below market rate credit line directly from the U.S. Treasury. That means the government has more responsibility to make sure that each company is properly overseen. Instead, the government turned a blind eye because the government was convinced that both were serving a function to the common good. As such, three very destructive behaviors were materializing and the government, which should have made sure to curb it, was looking the other way.
1) As the market heated up, both began to increase their own exposure in riskier loans. Here is how one article described what both were doing at the height of the real estate boom.
Mortgage repurchaser Fannie Mae has purchased or guaranteed $310 billion in Alt-A loans, or 12 percent of the company's single-family mortgage book of business, the company said in releasing its 2006 results.
Alt-A loans are those with reduced documentation requirements or other features that make them riskier than prime loans, but which have performed better than subprime loans. Many lenders are experiencing problems financing Alt-A because investors who buy mortgage-backed securities have cut back on such investments because of fears about the housing and mortgage lending markets.
Fannie Mae's sister company, Freddie Mac, announced this week it would addressthe issue by giving experienced lenders 90-day commitments to buy their Alt-A loans, enabling borrowers to lock in rates.
Fannie Mae officials said they believe the Alt-A loans they guarantee have "more favorable credit characteristics than the overall market of Alt-A loans," because the loans must comply with Fannie's guidelines, and are originated by lenders who specialize in prime loans.Fannie said about 1 percent of its $310 billion Alt-A book was "seriously delinquent" as of June 30, but that the guarantee fees on such loans are higher to compensate for increased risk.
What this article says in a very matter of fact is that both these giants were beginning to loosen their own restrictions and they were aggressively taking positions in more risky loans. Why? Here is why this should upset every. Look at Fannie Mae's mission statement.
At Fannie Mae, we are in the American Dream business. Our Mission is to tear down barriers, lower costs, and increase the opportunities for homeownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities, and our nation as a whole.
So how, exactly, is getting into mortgage niches that were already thriving without them in anyway helping to increase opportunities in homeownership? Those opportunities were being serviced just fine with either company's help. These two companies made loans tailored normally to sub prime and Alt A type borrowers not to help more people get loans, those people were already getting loans from outside sources, but rather because they saw an aggressive opportunity to make money. In other words, they took excessive risk to make more money and they did a lot of it using tax payer funds.
What was happening at the time is totally scandalous. At the time that both aggressively moved into both Alt A and sub prime, both Alt A and sub prime were thriving as niches. Of course, when the article says Alt A and sub prime, what it means is that each loosened their restrictions to approve folks that would normally find their way into each of those categories. Why would they loosen their restrictions so much though? There was plenty of money and banking interest in each of these much more highly risky loan classes by private money. Why would these two then take anything more than a token position in either? Neither niche needed their support to thrive.
This is what Barney Frank, Chris Dodd et al overlooked when the turned a blind eye to regulating and overseeing both. Had they performed proper oversight, this risky behavior would have been revealed and stopped. Rather, in their myopic pursuit of letting both lend aggressively into underserved areas.
Why did they do this? See how a former employee of the company explained it...
A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above
straight treasury yields.This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments. With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong
underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.
...
While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”. Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency. A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective
The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose. While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile. Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”. It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable
housing programs”. Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.
In layman's terms, Fannie/Freddie figured out a way to use debt to buy debt and make money because the debt they bought paid more than the debt they borrowed. One of the main reasons for this is that being an extension of the government, a GSE, allowed them to issue corporate debt at far reduced debt. Because this became a near sure thing, both figured out that the more debt they issued the more they would make. As such, they began to get more and more aggressive. They saw this as a no lose proposition. This is exactly the sort of risky behavior that folks like Chris Dodd should have been overseeing. Yet, they looked the other way because they were convinced that Fannie/Freddie were committed to providing loans to underserved areas.
1 comment:
isn't this the same as check kiting. i remember few years back, there was a company that leased GM automobiles. they became the largest lease company in GM. the problem was almost all of their leases were fraudulent. in order to keep going, they kept leasing more and more cars. in other words, because they had such a presense at GM with the number or lease cars they had, they were able to lease more and more and more. using debt to make money on debt.
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