I am hearing pundits blame Freddie Mac and Fannie Mae for the Credit Crisis gripping the world. Not only is this disingenuous but it is wrong. Freddie and Fannie have helped millions of Americans buy homes. For years, Freddie and Fannie bought most of the mortgages originated by banks, and then packaged and sold them to pensions and mutual funds. Their securities are considered some of the safest investments available, and it would be hard to find a government bond mutual fund that did not hold Fannie and Freddie bonds. Freddie and Fannie, using their low cost of capital, borrowed huge sums that allowed them to buy mortgages. They made money on the spread between their low borrowing cost and the interest they earned on the mortgages they acquired. This process allowed banks to make more mortgages than if they were to hold their mortgages. The mortgages Fannie and Freddie would acquire had to meet strict guidelines and this made banks make loans to to creditworthy borrowers who put down equity to acquire their homes. Through this process, Fannie and Freddie not only allowed banks to make more home loans, their low cost of capital kept interest rates low for consumers.
Banks have always had programs for subprime borrowers. These loans had higher interest rates and banks kept loan loss reserves for these loans. The implication I am hearing is somehow these niche programs, and poor, uncreditworthy borrowers, have sunk the financial world with Fannie and Freddie as the facilitator. No way. In many cases, until late 2006, Fannie and Freddie could not even buy subprime mortgages due to their strict underwriting standards. Fannie and Freddie securities primarily held traditional thirty-year mortgages and other, similar mortgages made to good credit borrowers that had made down payments of 20% or more. These are not the mortgages causing today's problems.
The idea that poor people suddenly decided to buy a home, paid too much and then stopped paying their mortgage is false. Yes, this did occur, but traditional banks have dealt with this type of borrower for years and knew the risks they posed. The problem is, and will continue to be, the non-subprime buyers that used subprime financing to support their lifestyle, and then could not afford the mortgage payments when the terms of their mortgage reset. Borrowers across the credit spectrum used subprime mortgages because of their low "teaser" rates. Home buyers looked for low monthly payments - the lower the better - and subprime mortgages had the lowest monthly payments (and most brutal reset terms). The home buying process became akin to buying a car. Mortgage brokers started with the amount a buyer could pay per month and then worked backwards to find a mortgage that fit the needed payment schedule.
No one worried about subprime mortgages' nasty resets when the "teaser" periods ended, the loans were going to be refinanced anyway. Mortgage brokers had solved the historic boom / bust cycle of the mortgage business. All they had to do was sell home buyers mortgages that had to be refinanced every few years and a steady stream of customers kept coming back and paying the refinance fees over and over. Borrowers had low payments and lived large, and mortgage brokers had high fees that recurred every couple of years - everyone was a winner.
The banks and finance companies, using the same process as Freddie and Fannie, stepped in to meet borrower demand. They would borrow money, allow banks and mortgage companies to create arcane mortgage products and then package and sell these mortgages to other firms. Banks jumped at the new sources of capital and business opportunities. Firms like Washington Mutual, Countrywide and New Century Financial, unleashed from the shackles of Freddie's and Fannie's old fashioned underwriting, boomed with their new banking friends.
The securities backed by the new mortgages got ever more inventive and complicated. The securities were so new and had so many different terms, the models used to price them could not incorporate all the various market scenarios (and no packaged loan security could ever have been sold with a 20% plus default assumption). None of these mortgage-backed products were Fannie or Freddie bonds. They were created and issued by Bear Stearns, Lehman Brothers and a host of other Wall Street firms. These are the mortgages that cannot now be priced.
Here is a quote from Warren Buffett from a recent article from the New York Times:
He called the current crisis an economic Pearl Harbor, requiring immediate action. Its biggest single cause, he explained, was the real estate bubble. “Three hundred million Americans, their lending institutions, their government, their media, all believed that house prices were going to go up consistently,” he said. “Lending was done based on it, and everybody did a lot of foolish things.”
As far back as 2003, Mr. Buffett had warned that the complex securities at the center of today’s troubles — once so profitable, but now toxic — were “financial weapons of mass destruction.” These securities were engineered by the math quants on Wall Street, and in the interview Mr. Buffett expressed his disdain: “Beware of geeks bearing formulas.”
I know several non-subprime borrowers who used subprime mortgages due to their low rates. The whole real estate bubble was caused by people thinking they had to get real estate because prices were always going to rise, or felt that the equity in their house was a source of idle cash. Mortgage companies met consumer demand, and subprime mortgages with their variable payment options were their prime tool. These mortgages allowed people to live way beyond their means. When people saw friends, co-workers and neighbors buying new cars, motor homes, home theaters, and taking first class vacations due to these new-fangled mortgages, the race was on. In many cases subprime mortgages, with those attractive teaser rates, were the easy answer. Homes became quasi-banks providing a seemingly endless source of lifestyle cash.
These mortgage securities, not Fannie and Freddie bonds, are the securities that cannot be valued and lead to the Credit Crisis and the $700 billion bailout. Freddie and Fannie bonds are some of the most liquid, and highest quality bonds in the world. The exotic mortgage bonds that were created by investment banks using complex mortgages and complex pricing models and formulas are what cannot be valued. The pricing models are worthless in today's turbulent financial markets. No one wants to be the first to buy these securities because of the fear of paying too much. This is why the Government is going to make a market in these securities. None of the securities the Government will buy are Fannie or Freddie bonds.
Fannie and Freddie are huge government bureaucracies and are not above reproach. They have historically been the domain of Democrats and championed by left, and have been full of corruption over the years. But they have played an invaluable role in expanding home ownership in the United States. However lax Congressional oversight has been, Fannie and Freddie are not responsible by themselves for the Credit Crisis.