Government Saves Fannie Mae and Freddie Mac in Unprecedented Bailout
Over the weekend, Henry Paulson and the United States Treasury decided to bail out mortgage giants Fannie Mae and Freddie Mac. This unprecedented move falls into the pattern of recent huge government bailouts that cater to the “too large to fail” theme and pushes us further towards true Socialism. We must ask ourselves: why did the government feel the need to bailout Fannie Mae and Freddie Mac, and what would have happened if they didn’t?
It was an interesting weekend: McCain/Palin took the lead in a few major polls over Obama/Biden, the 2008-2009 NFL Season began, Britney Spears actually acted normal at her attempt at yet another comeback, and I lost my Fantasy Football quarterback Tom Brady to a knee injury. But I digress. No doubt the most significant news of the weekend was the announcement to bailout or takeover mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC).
Who are Fannie Mae and Freddie Mac?
For those who don’t follow the financial secondary markets, Fannie Mae and Freddie Mac are Government Sponsored Entities who were chartered by Congress many administrations ago to purchase and hold or sell mortgage backed securities that they buy from banks and hedge funds to final investors. FNMA and FHLMC are (or should I say were) privately held corporations as far as their stocks go, but had the benefits of being government sponsored in the form of the bailout option and a blank checkbook. I hit on Fannie and Freddie’s role a bit in a previous article about another infamous bailout of Bear Stearns here.
In the simplest form I can express, FNMA and FHLMC buy closed loans from a mortgage lender (i.e. Wells Fargo, Bank of America, etc), and hold them until they can find a final buyer. The final buyers buy them from Fannie and Freddie and hold them for the term of the mortgage (typically 15 or 30 years). If you have or ever had a mortgage, I’m confident you saw the unsightly number of the total amount you pay in principal and interest over the course of the loan, which is typically 2 to 3 times the amount of your initial loan amount. Thus the final investors are the ones who make the large majority of the profit, however they must have the capital to pay for the mortgages plus the premiums up front. So the ultimate benefit of Fannie and Freddie is to free up the capital of the retail banks (the ones you get your mortgage from) so they can continue to freely and quickly lend on new mortgages.
Everyone can argue all day over the necessity, or lack of, for Fannie Mae and Freddie Mac, but they were chartered into existence in the 1970′s and have been a shoulder to lean on for banks ever since. Retail banks give out many types of mortgages, but the most popular is the “conventional” loan, which is backed by Fannie and Freddie. Therefore, they know that once they fund a conventional loan they can immediately turn around and sell it off. This option lead many banks to ease up their guidelines, knowing they could sell loans off regardless of the quality, so long as it fit Fannie and Freddie’s guidelines. Thus with loose guidelines, more people who wouldn’t normally qualify for a loan were getting loans, and this fueled the fire that lead to many of the foreclosure issues we’re facing.
Why did the government bail out Fannie and Freddie?
Hopefully the government had a good reason for spending upwards of $200 billion and taking of over $5 TRILLION (yes, TRILLION) in loans, right? Experts on both sides have debated heavily lately over if it was necessary to bail them out. One thing none seem to point out that I mentioned in the article linked above is that the government gave basically a “blank checkbook” to Fannie and Freddie to buy loans that banks could not sell on the secondary market. Fannie and Freddie also loosened their guidelines in response to the failing mortgage industry over the last year and took on lower quality loans than they normally would have, and in larger quantities. Thus the government is hypocritically and indirectly bailing out Fannie and Freddie because of the losses they took in part from the government infusion of capital into them.
Many people on the pro-bailout side are saying the bailout was necessary to keep from a meltdown in the financial market and the possibility if a global financial crisis. With the government controlling the majority of the mortgage market now, the pro-bailout supporters are saying this will show confidence in the market and will encourage banks to lend more and use Fannie and Freddie in a larger role than they ever have, thus leading to more loans at lower rates due to increased competition in the conventional niche.
On the flip side, there are a few points to note. From personal experience in the mortgage industry I can tell you that government backed loans (FHA or VA loans) are harder to get and are under stronger scrutiny from lenders. The alternative are conventional loans or specialty “portfolio” products from banks (typically reserved for customers with great credit or strong history with a particular bank). With the alternative of conventional loans now becoming government loans, guidelines will be stricter and loans will be under more scrutinization and thus harder to get. This may have lead to less lending and a decrease in the availability of credit for potential homebuyers, which is not necessarily a bad thing. As we have seen, homeowners who choose exotic mortgage products without a down payment and knowledge of the consequences and terms of their loan can have major effects on the housing market when they being to default or foreclose. The government seems to agree also, as Down Payment Assistance programs that allow buyers to purchase a home with no money down have been outlawed as of October 1 of this year and have been advocating for tighter credit guidelines.
What would have happened with no bailout?
This topic is very debatable and subject to much speculation since we will never know. However, an understanding of Fannie and Freddie’s role in the market is needed to brainstorm on this. While there is no right or wrong answer, a likely possibility would be a return to banks making smarter decisions as it would be their own capital on the line for mortgages. Another effect in a world with no Fannie and Freddie would be more accountability for poor decisions by banks and would likely see several major banks going under due to having to accept the losses on loans they wrote. While the effects would surely be felt in the short run, a more stable credit system may have likely arose instead of the one we have doomed ourselves to with major companies banking on the government to bail them out if they experience losses.
The taxpayers are surely footing the bill on this, with the upfront cost estimated to be at least $200 billion. That much money could have put sure footing on the Social Security system for years to come, or helped to go towards funding other necessary government programs. Instead, we blew open the lid on our already out of control national debt and have set a precedence to increase the debt further.
Another reaching effect of this is the precedence that has now been set. With the government stepping in just this year alone to bail out Bear Stearns, IndyMac Bank, and now Fannie Mae and Freddie Mac under the banner that they were all “too big to fail”, one must ask, where will they draw the line? In the past the government has bailed out Chrysler and the Savings and Loan industry in the 80′s, so who is to say that they wont extend a hand to any of the major automakers or credit card companies that are hurting? Does this set the stage for a “me too” philosophy? Or on a more personal level, if they can bailout large companies for bad risks, why can’t they bail out every individual who is behind on their personal mortgage or bills?
It is up to you to decide what you feel the role of the government is when it comes to accountability for businesses that take on large risks, or even when it comes to providing an out for your personal decisions and give you an alternative to personal accountability. Also we must decide as a nation, where do we draw the line between a free market economy and a socialist economy? In socialism and communism, the government is the largest employer and the largest business in the nation and controls all major industries. The government just crossed the fine line into the mortgage business, and definitely has not closed the door to stepping into the energy industry. Where will they stop?