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Friday, July 11, 2008

Analyzing the Impending Doom of Fannie Mae and Freddie Mac

If you are merely a layman, you might not care what happens to Fannie Mae and Freddie Mac. You might even say to yourself that they should fail if they took on too much risk. Unfortunately, the nature of the beast is such that neither can fail, and without them, we no longer have a mortgage market. The reality is that Fannie and Freddie's impending doom will wind up being a burden on all current and future homeowners. Furthermore, there will be all sorts of analysis of the situation and almost all of it will be rather uneducated.

Even during the height of subprime's popularity, loans securitized by these two entities accounted for more than 60% of all loans in total. In other words, these two entities aren't merely important players but rather they make the market go. The problem in fact is not that we may have to bail them out. We will have no choice. The problem is how we came to a place where two entities wield so much power.

Both Fannie Mae and Freddie Mac are what is known as Government Sponsored Entities. That means the government created them, and thus, they enjoy special privileges that other companies don't. Here is how my colleague at Red State analyzed it.

First, a few words about the GSEs. As you know, they borrow money from investors and use it to buy mortgages. Their cost of capital is uniquely low for privately-owned entities, because they have always benefited from two things: they’re allowed to buy only very safe mortgages that are unlikely to default; and there has always been an unspoken assumption that the Federal government would guarantee their debt. (A third entity, the Government National Mortgage Association, or “Ginnie Mae,” actually does have an explicit government guarantee.)

While they are so called GSE's, they are also for profit publicly traded companies. (Fannie Mae trades on the NYSE under the symbol FNM) Immediately, there is a conflict of interest in the scope and philosophies of these two companies. Both were created to expand the scope of mortgage lending and provide Middle America with more affordable mortgages. Of course, it is difficult to square that mission with the mission of any publicly traded company, maximizing profits.

The real problem with allowing Fannie and Freddie to fail is this. They don't merely insure and securitize loans, but they also underwrite them as well. This is something only mortgage professionals understand. In fact, any so called conforming loan is in fact underwritten by Fannie Mae and Freddie Mac. Each of these have software systems known as Desktop Underwriter, Desktop Originator, and Loan Prospector. These three software systems are the ones making the underwriting decision. It is NOT in fact the bank through which you receive your mortgage. Since each bank wants their loans insured by either of these two entities, the loans must be acceptable to them. As such, they are the ones making the decisions. It is much like FHA makes the decisions on their loans. Of course, FHA holds onto a signficantly smaller portion of the market.

Since at least 60% of all loans are always insured, securitized, and underwritten by these two entities at any given time, there is no way they can fail. If they fail, the whole system falls apart. Therein lies the rub. In fact, the problem is not that the tax payers need to bail out another mammoth financial institution. The problem is that a system has been created where two mammoth financial institutions control the bulk of the mortgage market. Furthermore, this is a system that our government created.

The logic behind their creation was rather simple, economies of scale

Economies of scale can be enjoyed by any size firm expanding its scale of operation. The common ones are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), and marketing (spreading the cost of advertising over a greater range of output in media markets). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost
(SRATC) curve down and to the right.

In other words, if the government created these bohemoths, they would use their size to drive down interest rates and make mortgages more available and easier to attain for everyone. In many ways, that has happened. There is no doubt that mortgage rates are lower and more mortgage products are available because of these two.

On the other hand, having two bohemoths dominate the market the way they do also has a nefarious downside, a moral hazard.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

These two bohemoths are prone to taking on risk they never would take on if they didn't wield so much power. That's exactly what each has been doing for years, and now we are on the brink of a significant bailout. The current problems with Fannie and Freddie are caused by the natural moral hazard the government built into them when they were created. The government looked to create one advantage and brought with it one much bigger disadvantage.

The current problems of both leave room for a serious debate about the future of mortgages. Do we really want these two dominating our markets in the future? That is a question for future posts.

With that, let's examine some solutions. Here is my solution to ending the Fannie/Freddie fiasco.


Anonymous said...

Thanks for a concise summary of the situation. I understand the moral hazard issue and the too big to fail problem but I am not sure that I understand why they are in trouble at the moment.

I recognize the subprime and alt-a problems but my understanding from your post is that these two agencies have only been involved in conforming mortgages. Don't these have a maximum 80% LTV or require insurance if the LTV is higher?

I believe that arrears and defaults on these types of mortgages are lower and there is some equity protection when they do default.

mike volpe said...

That is a great question and frankly the 64 thousand dollar question. Everything you said is accurate. In fact, they shouldn't be in trouble and yet they are. They weren't involved in sub prime and they were supposed to have kept their underwriting fairly even. The problem is that their underwriting is so complicated and sophisticated that if fannie and freddie decided to loosen restrictions most folks wouldn't even notice. Frankly, I don't have an answer for why they are in trouble and we all should.

mike volpe said...

By the way, while I can't prove this beyond all doubt, I am almost certain that the reason that they are in trouble is because they got far too weighted in low and no money down loans. Those became chic and they both got their fair share and I suspect that is what got them in trouble.

Anonymous said...

ANY TIME the government gets involved in anything beyond its most basic functions, it causes severe market distortion. Capitalism works better. Why is that so hard to understand?

mike volpe said...

No argument here on that sentiment, however the problem is more complicated than such simple logic. The cat is already out of the bag, and you can't put the proverbial genie back in the bottle. We have now created a system dependent on these two. You can't just remove them. The system would be in total chaos. This problem has no easy solutions.

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Anonymous said...

Thanks for answering my question earlier, pretty much what I thought.

Based on this afternoon's share price move it has all been solved anyway.

Anonymous said...

Question: I have a mortgage loan with a bank that is insured/underwritten by Freddie Mac. What happens to my loan if Freddie Mac fails? Thanks.

mike volpe said...

That's an excellent question and one that many folks are worried about. First, there is no way they will fail. They are simply too important to fail. That said, even if I am wrong, your loan, whether you like it or not, is in tact. Tht loan has long been securitized and turned into a bond. They guarantee that loan for the investor. Now, if you, and lot's of others go bad on said loan, and fannie also goes bad, then the investor loses all sorts of money. So, please make sure your payment is on time.

This gets complicated however the loan that you have is NOT affected by the current problems of fannie and freddie. I don't know if that is good news for you or bad, since some folks are hoping that if fannie fails that means they are no longer responsible for their payment. No such luck.