This Choice IS Important

The Federal National Mortgage Association (Fannie Mae) is an interesting animal.

The government agency was started during the recession of the late 1930s to help banks make more housing loans.

The basic premise: Fannie Mae would buy mortgages from banks, who could then re-lend the money.

Only, Fannie Mae was much more generous than banks were.

Instead of offering the typical five-year loan, with a required down payment of nearly 50%, Fannie Mae would buy loans that had a 30-year term and a down payment of 20%… and then it would charge an insurance fee to cover any losses.

These terms, along with a borrower’s good repayment history, became known as “conforming”… that is, they conformed to what Fannie Mae wanted.

Fannie Mae wasn’t generous with its own money, because it technically didn’t have any.  The entity was funded by selling bonds. The loans and small insurance premiums then backed the bonds.

The question is: Why would investors who bought Fannie Mae bonds be happy with the new terms on offer to borrowers when banks weren’t comfortable with them?

That’s a good question.

Everyone assumed that the U.S. government backed the bonds Fannie Mae was selling. The problem was that the government only guaranteed a paltry $25 million, even though Fannie Mae eventually had trillions of dollars in loans outstanding.

Fannie Mae went public in the 1960s, and threw off lots of dividends to equity investors, interest to bond investors, and bonuses to management.

Things were great… right up until they weren’t.

Fannie Mae, along with its sister company Freddie Mac (FHLMC), went bust in the summer of 2008.

The money coming in from home loans during the dark days of the financial crisis, along with funds from the insurance premiums, simply weren’t enough to make good on all the bonds outstanding. So the U.S. Treasury put the two companies into conservatorship.

Not bankruptcy, mind you. Just conservatorship. The ultimate hole in the balance sheet was $180 billion… just a touch above the government’s $25 million guarantee… but that was okay, because the Treasury announced it would make all bondholders whole.

And that’s when the world of bond investing changed.

The U.S. Treasury’s decision to fully back the bonds of the two housing companies, which were both private entities by that time, even though they started as government agencies, effectively nationalized the firms.

Any debt they incurred was a de facto debt of the U.S. government.

Voila!

Fannie Mae and Freddie Mac could issue any amount of debt they wanted to and buy anything they felt like, because repayment from underlying homeowners didn’t matter at all.

Uncle Sam would pay, as was made clear by the $180 billion cash infusion.

During the crisis, and in the years since, Fannie and Freddie, along with the Federal Housing Administration (FHA), have backed over 95% of new home loans.

The explosion in demand for Fannie and Freddie funds meant that the two companies received an enormous inflow of insurance premiums being charged on new mortgages.

This led to a dramatic increase in revenue for the two companies, and a quick repayment of the $180 billion that taxpayers provided in 2008 to bail them out.

This all sounds good, but keep in mind what happened…

Fannie and Freddie were only able to continue operations because they werebailed out.

Then they were only able to borrow more money to buy home loans because now they had the explicit backing of the U.S. taxpayer.

These are not private companies. They are effectively agencies of the U.S. government.

When the U.S. government takes on the responsibility for your debt, both past and future, people will lend to you freely, but their willingness to give you money has NOTHING to do with you. It has everything to do with the government’s guarantee.

Now we have to decide what to do with Fannie and Freddie. Their stock is still traded, and they still have the structure of private companies.

Should they be fully nationalized and operate like the FHA, or cut loose?

The choice does matter.

If the entities are sent along their way, then they shouldn’t carry the backing of the U.S. government anymore, which means their ability to borrow freely and cheaply will be greatly diminished.

This would drive up the cost of mortgages and slow down the housing market.

On the other hand, if the two companies are fully nationalized, they become pawns in the political game, where political motivations drive decisions about lending (lend more to that group over there, lend less to this group over here, etc.).

Indeed, some of this went on before 2008.

We want to avoid a repeat of the previous situation, where the companies made private decisions and earned private profits, but in the end, we as taxpayers took the losses incurred.

This falls into the category of privatized profits and socialized risks.

Unfortunately, it’s the most likely outcome.

Congress doesn’t want to actually nationalize Fannie and Freddie because the government would then have to assume all of their risks, and show their liabilities as outstanding on its balance sheet.

While the rebound in housing and the increase in the insurance premiums have repaired their corporate balance sheets, another drop in housing could cause more damage, as well as losses.

At the same time, these companies were effectively the lenders of last resort for home mortgages during the depths of the crisis, so no one wants to stop the money flow for fear of creating a new crisis in housing… or making another downturn worse.

Without clear direction for these two entities, Congress gets to have it both ways.

It can keep money flowing in from bond buyers who rightly believe that the U.S. government backs all bonds, and keep the assets and liabilities of the two entities from appearing on the country’s books.

Of course, this fools no one.

No matter what Congress says, or in this case, doesn’t say, everyone knows who’s on the hook for future losses: U.S. taxpayers; the REAL payers of last resort.

Rodney

 

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Categories: Housing Market

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.