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Jump Analysis: 
Six Myths - Fannie and Freddie Caused the Housing Bubble
Author: Bikram Pandey
Last Update: 3:34 PM ET January 17 2012

In a new six-part series, will examine a number of commonly held myths that can adversely affect investment decisions of both individuals and financial professionals.

In this second article, we will focus on the widely held belief that Fannie and Freddie, spurred on by government policies, played a central role in the housing bubble and its subsequent collapse.

Six Myths - Did Fannie Cause the Housing Bubble?

It has been more than three years since the housing bubble burst, but the economy is still reeling from its widespread negative impacts on the financial system, employment, and asset values. Not only did the collapse drag the US economy down into the deepest recession in seventy years, but it also shook the entire global economy and the world’s financial system to its core.

The issue is serious and deserves a careful analysis to avoid the repeat of cascade that pushed six million homeowners in foreclosure and forced more than 10 million people into unemployment.

Perhaps, public commentators are just looking for a simplistic explanation for a naive public when they attribute the housing market collapse to government policy in general, and Fannie Mae and Freddie Mac in particular. For the right-wing political ideologues making the same argument, it is more likely an effort to rewrite history, while deflecting blame away from their own politics.

The facts of the case, however, are often left in the dust.

How did it all start?

To understand the role government policy played in the collapse, one has to take a longer-term view of the history and analyze the various players that supported the buildup of the housing market and understand their motivation. Mortgage brokers, mortgage bankers, financial depository institutions, and the secondary mortgage markets all benefited from the ever–expanding housing boom and raked in large profits. Regulators looked the other way ignoring widespread fraud, while lawmakers trumpeted the virtues of home ownership and feasted on the campaign contributions served up by the financial industry.

Deregulation, weak risk management, predatory lending, unregulated derivatives, and Wall Street greed, all contributed to the bubble, as did irresponsible home buyers; but it is difficult to identify a primary cause – the one which could have prevented the bubble from developing in the first place.

The arguments made by the right-wing extremist that government sponsored agencies are the root cause of the housing market boom and bust just don’t hold up under careful investigation.

List of Allegations

The quasi-public, but profit making companies, Fannie Mae (the Federal National Mortgage Corporation) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are the direct target of their wrath.

They believe that the bubble and subsequent collapse was due to federally guaranteed mortgages, rather than the aggressive activities of the private mortgage businesses and the widespread mortgage fraud. They point to government policies, under the Community Reinvestment Act, that promote lending to the poor or people living in marginal neighborhoods.

“These requirements compelled normal banks to compete for mortgage borrowers who were at below average income and caused underwriting standards to decline and increase the number of weak and high risks loans far beyond what the market would produce without government influence especially in the last ten years to 2007,” argues Peter Wallison, the lone dissenter in the Financial Crisis Inquiry Commission’s report.

Wallison goes on to argue that, when the bubble began to deflate in mid-2007, and the low-quality, high-risk loans began to default in large numbers, Fannie and Freddie purchased a large numbers of these loans, they allege, to meet the Department of Housing and Urban Development or HUD’s affordable housing goals.

Questionable and Faulty Data

The thrust of the Wallison’s argument is based on the collection of articles published by Edward Pinto at the American Enterprise Institute who formerly served as chief credit officer at Fannie Mae more than twenty years ago. The most of the data used in his research including his numbers on subprime mortgages are Pinto’s own estimates, because neither Fannie, Freddie, nor the mortgage industry publishes these data.

Pinto claims that 25 million mortgages, or nearly half of all 55 million mortgages written by the agencies, were of inferior quality as the direct result of the HUD’s policies. If Pinto’s estimates are correct, it would raise serious questions about the government’s role and the viability of the entire mortgage industry where every other borrower is subprime.

But Pinto’s estimates, that Wallison has called “research,” have mostly been dismissed by economist and housing market analysts as invalid, especially because of his expanded definition of what constitutes a subprime loan, as well as his default rates that are little more than guesses based on data that cannot be verified by anyone.

Right Wing Echo Chamber

Nonetheless, there has been a growing chorus of blame targeting Fannie and Freddie, which has gained steam during the Republican primary season. The self-styled financial gurus and talk radio hosts and publications controlled by Rupert Murdoch spew a steady stream of right-wing propaganda and beat the drum of blame against Fannie and Freddie.

The typical rant is reflected in a Wall Street Journal editorial on December 23, 2011, which states: “Far from being peripheral to the housing crisis, the SEC lawsuit shows that Fannie and Freddie were at the very heart of it.”

The facts clearly show that Fannie and Freddie did make disastrous decisions by acquiring risky loans at the height of the housing market bubble in 2006 and 2007. Both agencies had lagged behind the market in writing and holding high-risks securities; and, in fact, they lagged so far behind that they felt pressured to increase their exposure in order to increase their market share and associated profits.

So it was the profit motive that dictated their decision to increase subprime loan exposure rather than the government’s affordable housing goals.

The editorial went on to say, “Private lenders made many mistakes, but they could never have done as much harm if Fan and Fred weren't providing tens of billions in taxpayer-subsidized liquidity to lend on easy terms to borrowers who couldn't pay it back.”

This statement is also far removed from the reality. Most analysts agree that the Fannie and Freddie were the victims of the crisis and of their own hubris, rather than the initiator. They had already stretched their balance sheet to the limit before the bubble started and did not have the capital or the appetite to be its primary driver. Their mistake was in expanding their holdings just before the bubble burst. In addition, the quality of mortgages held by the Fannie and Freddie proved to be relatively superior than held by the largest banks and brokerage houses.

Even if Fannie and Freddie had wanted to be a bigger player in the subprime lending, they would not have been able to capture a significant share of the market. The largest commercial banks along with the six largest investment banks were the dominant players driving subprime lending growth.

The editorial ended with a ridicules proclamation that, “Congress created the two mortgage giants as well as their ‘affordable housing’ mandates, and neither the financial system nor taxpayers will be safe until Congress shrinks the toxic twins and ultimately puts them out of business.”

This blame “Fannie and Freddie” and “toxic twins” story has been repeated in numerous commentaries and editorials over the last several years in the Wall Street Journal; and it is often trumpeted by conservative, talk radio programs. The erroneous facts and distortions are frequently repeated by presidential candidates in public debates and recited by members of the congress.

The reason that the editors of the Wall Street Journal want Fannie and Freddie out of business is obvious. The large banks and financial institutions are the paper’s most important advertising clients; and they will profit from the agencies demise.

Even the Financial Crisis Inquiry Commission was not immune from the blame Fannie and Freddie drumbeat based on Peter Wallison’s dubious facts; nonetheless, he was the only commissioner of the ten-member panel who wrote an angry dissent.

New York Times reporter Gretchen Morgenson and mortgage securities analysts Joshua Rosner in their new book, Reckless Endangerment, also make bold and passionate assertions in laying most of the blame at the feet of the Fannie and Freddie.

However, their passion is not based on verifiable data and analysis. They offer their opinions, but little in the way of hard evidence that can be verified by others. The Morgenson-Rosner Book’s slipshod analysis is frequently cited by shameless politicians who are seeking campaign contributions from those against financial service industry regulation.

Fannie and Freddie Made Mistakes

Make no mistake, Fannie and Freddie did make serious errors. The profit making enterprises’ primary responsibility was to their shareholders. But rather than profiting from their participation in subprime loans, they ended up losing $230 billion when the housing market collapsed.

Without question, Fannie and Freddie have been used as a cookie jar by many politicians like New Gingrich, Christopher Bond, and Barney Frank, as well as by former bureaucrats like Robert Zoellick who now heads World Bank, Lanny Davies, and William Daley.

The revolving door between the government power brokers and the Fannie and Freddie management was unethical and deplorable, but did not directly lead to collapse.

The two government agencies failed because they made disastrous loans at the peak of the housing bubble with too little equity. Fannie and Freddie operated with a leverage of close to 99-to-1. Only a relatively small 4% decline in the value of their portfolios wiped out their entire equity.

Life Without Fannie and Freddie Liquidity

Fannie and Freddie currently provide the critical liquidity for loans to most qualified borrowers at a reasonable fee – something that most banks will never provide. Without the Fannie and Freddie participation in the mortgage business, lending to most middle class and working families will shrink, and only be available at a significantly higher rate from commercial sources.

Just look what banks are currently charging for auto loans and credit card interest rates. Credit card rates range between 18% and 36%, even when banks can borrow funds from the Fed at near zero and losses in the industry are substantially lower lending to subprime mortgage borrowers.

Without the competition from Fannie and Freddie, this reckless disregard for the borrowing public would manifest itself in the mortgage industry.

Fannie, Freddie Track Record
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Sources: Data collected by and from company press releases, filings and corporate websites.
Market data: BATS Exchange. Inc.

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