Fannie and Freddie
By 2008, markets were growing concerned about the government-sponsored housing-finance institutions Fannie Mae and Freddie Mac, whose financial health appeared increasingly tenuous. Fannie and Freddie weren’t to blame for the U.S. housing bubble, although the two firms had made many mistakes over the decades. But their takeover in summer 2008 triggered a worldwide financial panic.
Fannie and Freddie were actually minor players in the crazed lending of the 2000s, which was dominated by the private sector. Between 2004 and 2007 during the height of most crazed mortgage lending, private lenders originated three-quarters of all subprime and alt-A mortgage loans (see Figure 1.7). 11 The rest came from government agencies, including Fannie, Freddie, and the Federal Housing Authority.
Figure 1.7. Share of mortgage originations by nongovernment lenders, %.
Sources: Equifax, Moody’s Analytics
In 2006, the dollar amount of those private subprime and alt-A loans had reached a jaw-dropping $600 billion—about as much as all Americans collectively owe on bank credit cards. By contrast, government lenders made more than $100 billion in subprime and alt-A loans in 2006. Even in 2007, when the housing market was starting to crack, private lenders still originated more than $300 billion in sub-prime and alt-A mortgages.
This had the effect of shrinking the share of total residential mortgage debt insured or owned by Fannie Mae and Freddie Mac. At the start of 2002, the two agencies issued or guaranteed almost 54% of all mortgage debt. By summer 2006, their share had fallen to 40% (see Figure 1.8). That shrinking market share undercuts arguments that the agencies had inflated the housing bubble. In fact, it shows the opposite: The bubble was diminishing Fannie’s and Freddie’s position in the housing market.
Figure 1.8. Share of mortgage debt, %.
Sources: Federal Reserve Board Flow of Funds, Moody’s Analytics
Fannie and Freddie weren’t making prescient strategic decisions to pull back on mortgage lending; their government regulator had forced them to rein in growth after the agencies committed various accounting irregularities. Moreover, the two firms couldn’t compete with rapacious private lenders, who, thanks to securitization, could offer extra-low rates and irresistible terms to borrowers. In 2006, almost half the loans made by private lenders required no down payment and no documentation. Fannie and Freddie simply couldn’t play in that league, even though Congress had given them aggressive lending targets to help boost homeownership among lower-income and minority households.
Fannie and Freddie did play a significant part in the financial panic. As conditions began to weaken in 2007 and the private mortgage industry pulled back, the agencies attempted to get back in the game. The memory of their accounting scandals had faded and policymakers hoped they could prevent the housing market from unraveling. Fannie’s and Freddie’s originations of sketchy loans actually peaked near $160 billion in 2008, the year regulators placed them into conservatorship. The two agencies had jumped back into the housing market at precisely the wrong time.
Loss rates on Fannie’s and Freddie’s loans were still low by industry standards, but they were rising and starting to threaten the institutions’ thin capital cushions. The average commercial bank held $10 in assets for every $1 of capital; Fannie and Freddie’s ratio was as high as 70 to 1. Regulators never demanded the two firms hold as much capital as ordinary banks because their loans went to top borrowers. Now that they were lending to the less creditworthy, their capital was woefully inadequate.
As investors began to worry they might fail, Fannie’s and Freddie’s share prices plunged, and their borrowing costs rose. This made it harder for the two firms to extend mortgage credit just when policymakers were counting on them to help stabilize the housing market. Instead, mortgage rates began to rise.
Treasury Secretary Henry Paulson aimed to shore up investor confidence when in July 2008 he reaffirmed and expanded Fannie’s and Freddie’s federal credit lines. Investors were appeased only briefly; after that they grew even more convinced that Fannie and Freddie were headed toward insolvency. In early September 2008, with the backing of the Treasury Department, the FHFA placed Fannie and Freddie in conservatorship, effectively nationalizing them. 12 Where before they had been public-private hybrids known as “government sponsored enterprises,” now they were firmly part of the federal government. Their debt holders were safe, but their shareholders were effectively wiped out.