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Saturday, July 12, 2008

Fannie Mae/Freddie Mac: Socialistic Monopolies

I am sure when they were created by some well meaning politician, Fannie Mae and Freddie Mac seemed like a good way to extend credit opportunities to folks in the lower and middle class. In fact, Fannie Mae has its roots in FDR's New Deal. Freddie Mac was created in 1970. The concept for both is rather simple. Here is how Freddie explains it.

Congress found an ingenious way to stimulate long-term investment in housing without exposing the public fisc to the risk of substantial loss: it created government-sponsored enterprises with Congressional charters, and gave them the singular job of making markets stable, liquid and affordable in all economic environments.

The GSE model of housing finance has been a Congressional success story. By maintaining exclusive focus on the residential mortgage markets, as required by law, and by leveraging the efficiencies of a shareholder-owned company, the GSEs have developed extraordinary expertise in understanding and managing mortgage credit risk. This has resulted in a steady lowering of down payment requirements within the conventional market to the point at which the GSEs, with no government or taxpayer dollars, are able to provide nearly the same affordable mortgage products for their lenders to use with borrowers as the government provides through its on-budget FHA and VA mortgage programs.

Freddie is right that these entities were a way to provide stability and liquidity. There is no doubt that both have driven down interests and created outlets for more aggressive loans banks would never do with the secondary market created by both.

While everything I just said is true let's also never mind the spin by Freddie in the second paragraph. Neither of these companies is a success story and furthermore, they have not isolated the government from risk. While these companies are both private, they are still Government Sponsored Entities. That means they have access to government money. Furthermore, they have become so large that the government, and the tax payer by extension, is ultimately responsible for their solvency.

In fact, these companies act much more like Citgo in Venezuela than they do a company like Microsoft in America.

What these two companies did was create a "secondary market" for loans generally geared toward borrowers. They bundled these loans together and sold them off as bonds. Because banks had an instaneous buyer for bundles of loans, banks could count on instaneous liquidity. Since banks could count on instaneous liquidity, they could loan to more borrowers and be more aggressive.

That is the positive of Fannie Mae and Freddie Mac. The negative is that the secondary market for good loans is not a market. It is an oligopoly dominated by two players, Fannie Mae and Freddie Mac. Because of their sheer size and access to government funds, there is a natural barriers to entry toward any other entity challenging these two in providing a secondary market for the very best loan.

In economics and especially in the theory of competition, barriers to entry are obstacles in the path of a firm which wants to enter a given market.The term refers to hindrances that an individual may face while trying to gain entrance into a profession or trade. It also, more commonly, refers to hindrances that a firm may face (or even a country) while trying to enter a market, industry or trade grouping.
Barriers to entry restrict competitive in a market.

In other words, no one, not even Warren Buffet, Bill Gates, or Donald Trump would dare offer an alternative to Fannie and Freddie in securitizing good loans. Thus, if you wanted to get the very best loan out there, then ultimately one of these two will securitize it.

Of course, they will do much more than that. If they are going to securitize it, they will also make the decisions of approval. In other words, it is no longer the banks that decide whether a borrower is approved or not, but Fannie and Freddie. (they do this through multiple software systems known as Desktop Underwriter, Desktop Originator, and Loan Prospector) In fact, if these two are ultimately securitizing all these loans, ALL decisions are ultimately up to them. The whole entire system is ultimately controlled by these two entities. The overwhelming majority of all loans are in fact conforming loans, or loans securitized by these two.

In other words, the government created a mortgage system that was not only monopolistic but socialistic. After all, these two can claim they are private all they want, but in fact, they are Government Sponsored Entities. As such, they have access to government money and enjoy other perks other companies would not.

The tragic irony is that the private market is likely perfectly equipped to create a secondary market on its own. I know this because in the mid 1980's Lew Ranieri used these two as inspirations and created mortgage backed securities. These were the sub prime equivalents to Fannie Mae and Freddie Mac. The main difference is that he needed no government help to do it. While we all know what ultimately happened to subprime, it is a shame because it also offered the blue print for what the private market holds for mortgage securitization. Anyone who worked in sub prime after Ranieri created mortgage backed securities knows that there was an overwhelming plethora of product choice. There were many banks and each had slight alterations to their underwriting criteria, and all of them ultimately sold their loans onto the secondary market. Thus, in sub prime, if you had a borrower that had any chance of being approved, a good mortgage broker could find a bank that would accept them. Not so in prime. If Fannie rejects you as a borrower, you hope Freddie will. (they do have slightly different underwriting criteria) If both do, then you have to look elsewhere for a loan. If Ranieri could figure out how to turn risky mortgages into a securitization business, stronger loans would certainly have found private securitization.

Instead, we have to sort of private sort of government extensions that dominate the market. They make the rules and their rules are final. I know this because everytime I disagreed with underwriting guidelines in prime, the standard response from the bank was

those are the rules that Fannie/Freddie has

Banks have no choice but to go to one of them for the bulk of their loans. Banks don't want to hold onto most loans themselves. They would much rather fund them, sell them, make a little juice, and move onto the next loan. Since no one can challenge them, they operate no different than a monopoly. Since they are a creation and extension of the government, they are a socialistic one at that.

So, how can we resolve this problem. Here is my solution to ending the Fannie/Freddie fiasco.


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