Role of Fannie and Freddie in Subprime Crisis

It's Sunday morning and I've just finished watching "Sunday Morning" with Charles Osgood. This morning there was an Op-Ed piece by Ben Stein discussing the current financial meltdown resulting from Mortgage Backed Securities (MBS) particularly those weighted in the subprime category. An economist first, and a Republican second, Mr. Stein wove a tapestry of blame that implicated nearly everyone connected to the mortgage industry -- including deregulators (he even conceded that perhaps anti-regulators is more accurate) in Washington D.C. I thought it was fair...for the most part.


Not politically uncharacteristic, Mr. Stein launched the first rhetorical cruise missile at (paraphrasing) liberals who encouraged lending to those borrowers who could not make good. While I do not deny SOME causal relationship between this and the meltdown, I'm not convinced that it is a greater cause or, for that matter, even equivalent to the lack of regulation consistent with this administration (and Bill Clinton's) and the 12 of the last 14 years in which republicans have controlled Congress.


The first charge against liberals goes back to the Carter administration and the passage of the Community Reinvestment Act (CRA) of 1977. Conservatives (such as Larry Kudlow and George Will) like to say this is the "root" of the problem (I think irresponsible lending is the "root", but I digress). Perhaps the most startling aspect of this charge is that this crisis, allegedly caused by the CRA, was 30 years in the making -- not to mention that the U.S. enjoyed the lowest foreclosure rate in its history for nearly 25 of those 30 years of the CRA's existence. Conservatives conveniently and irrationally bestow this credit upon Ronald Regan.


According to Ellen Seidman, Executive Vice President for National Policy and Partnership Development at ShoreBank Corporation and Director of the Financial Services and Education Project at the New America Foundation, the record enforcement of the CRA led to responsible lending resulting in the relatively low foreclosure rate during its exitence but:

CRA enforcement became a lower priority for bank regulators after 2001. My successor at the Office of Thrift Supervision, in fact, led an effort-eventually thwarted-to unilaterally loosen CRA regulations for institutions with more than $1 billion in assets. See 70 Fed. Reg. 10023. Nevertheless, CRA regulations were eased more generally in 2005. See 70 Fed. Reg. 44256. (http://www.newamerica.net/blog/asset-building/2008/no-larry-cra-didn-t-cause-sub-prime-mess-3210).




It's quite obvious that the lack of enforcement of CRA lending provisions (which unarguably occurred during the Bush Administration) is clearly closer to the explosion of the mortgage crisis and therefore warrants far more blame than the CRA itself. It's tantamount to blaming the Social Security crisis on FDR simply because he founded the program -- when a program is in crisis, it's hardly convincing to lay blame at its existence more so than its management.


The follow-up allegation to this initial charge (one spouted by John McCain in the second debate) is that Fannie Mae and Freddie Mac caused this crisis. This very statement shows just how little Sen. McCain understands how the two lenders operate let alone their association with this particular crisis. Allow me to lay out as best I can the Fannie/Freddie role in this industry, then I will mark the areas for which they were at fault.


First, Fannie/Freddie are not primary mortgage lenders -- meaning that no borrower ever goes to Fannie/Freddie and says "I want a mortgage." If one believes, as I do and as conservatives rightly state, that the root of this problem is borrowers taking out loans they cannot afford -- then, it is totally inconsistent to say Fannie/Freddie are a "root" cause since they are NOT a primary lender. It, however, is perfectly consistent to say the lender or, perhaps even more so, the lender's loan processing company (as well as irresponsible borrowers) are root causes.


But just because Fannie/Freddie are not root causes doesn't mean they're entirely innocent either. Fannie/Freddie are what's known as "second-tier mortgage lenders" and it breaks down like this:

1. Borrower applies for a mortgage.
2. Something comes up that prevents the lender from extending credit to that borrower.
3. Yet borrower qualifies for assistance from Fannie/Freddie.
4. Fannie/Freddie subsidize a portion of the financing extended to the borrower for the purpose of shielding that lender from risk (something that has been going on since 1968).
5. Fannie/Freddie then, once all the papers are signed, buy the mortgage debt from the lending institution.
6. The lender, or sometimes a third party, owns the payment management side and charges a fee to Fannie/Freddie for this service (this too has been the case since 1968).

So Fannie/Freddie do not vet any borrowers, yet they do have standards -- standards that admittedly were loosened under the Clinton administration. So if Fannie/Freddie don't vet any borrowers who does the vetting? Either the lender or the loan processing company does, and Fannie/Freddie take them at their word - to which the lenders swear under penalty of perjury. If a lender lies to Fannie/Freddie about the credit worthiness of a borrower, that constitutes fraud.

So Fannie/Freddie then are victims too? Well, yes and no. It's entirely possible that they were duped by lenders and this is under investigation by the FBI. However, the FBI is also investigating them for doing the same thing in turn to other investors buying their MBSs. This is where things get interesting: while Fannie/Freddie were getting clobbered from these bad debts, they decided to sell them off which, in and of itself, isn't necessarily wrong -- asset liquidation is a basic part of any financial strategy. What they may have done and what they're being investigated for is having bundled these bad mortgages together and sold them off to investors all around the world under the false pretense that these securities, like T-Bills, were guaranteed by the Federal Government. (For a better understanding check out Jim Jubak on MSN.)

Now, that's pretty damn serious!! If you don't understand why, it's nothing to be ashamed of, but to help I'll refer to Peter Orszag, Director of the Congressional Budget Office, who stated on October 9 that the saving grace here is that people are still willing to lend to us. This salvation may have been catastrophically absent had the Federal Government not stepped in to comandere Fannie/Freddie. If Fannie/Freddie had been permitted to fail, the U.S. credit rating would have plummeted, and that would have been followed by a whole host of other financial catastrophes far worse than what we've seen thus far.

So Fannie/Freddie are hardly blameless for the exponential growth of this problem but they are quite far from ground zero. And what would that be? Well, nobody seems to be saying it yet but it's a combination between the way Credit Bureaus assess the credit worthiness of borrowers and the way lenders try to justify risky lending with high (and occasionally usurous) interest rates. This fundamental question has been begged: How does one quantifiably justify risk?

The next concentric circle falls to the lenders who bundled these mortgages, gave them bogus credit ratings, and sold them off to investors or second-tier lenders like Fannie/Freddie. Then come the insurance companies who over-issued credit default swaps against these MBSs without the assets to back them up. (Check out this link where Paul Solman of the Newshour explains the credit default swap http://www.pbs.org/newshour/video/module.html?mod=0&pkg=7102008&seg=3). And then, every investor who sold an MBS while fraudulently boosting its credit rating. Finally, lack of regulation (see http://seekingalpha.com/article/98651-don-t-blame-deregulation-for-this-crisis-it-s-all-about-lack-of-regulation?source=wl_sidebar).

For more info about the misdirected blame on Fannie/Freddie see: http://seekingalpha.com/article/98533-fannie-and-freddie-did-not-cause-this-crisis?source=wl_sidebar