Addressing Financial Crisis Misconceptions

Now that the entities known as Fannie Mae and Freddie Mac have been thrust to the forefront of national media coverage due to their rapid failures which have resulted in a multitude of emergency congressional hearings, cabinet sessions, press conferences and ultimate government conervatorship, many Americans have been left confused as to what role these two enterprises actually played in causing our nation’s financial crisis. Both Fannie and Freddie are commonly referred to as “government sponsored enterprises” or “G.S.E.s” and are the largest buyers and insurers of mortgages in the United States. These two entities held or backed a total of $5.3 trillion of mortgage debt in 2008, about half the outstanding mortgages in the nation. Fannie and Freddie were considered to be “government sponsored” since they were initially created and funded by the federal government, but shortly thereafter began operating as public corporations with their stock traded on the open market.

The Government Sponsored Enterprises

Fannie Mae was created as part of the 1938 Federal Housing Act when millions of low and middle income families could not afford to buy or retain homes after the great depression. After the depression depleted the cash reserves of most banks, prospective home buyers were faced with exorbitant mortgage interest rates as lending institutions were wary to part with precious capital. The Federal National Mortgage Association (Fannie Mae) was created to buy bank mortgages to enable the banks to free up more reserves to generate more loans at affordable interest rates. Fannie then pools the mortgages and sells them to investors, effectively making it the middleman between banks and investors.

In 1968, Fannie Mae was made a shareholder-owned corporation to decrease government involvement and later permit Fannie’s mortgage-backed securities to be sold on the open market. Shortly thereafter, the government established the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970 to further expand the secondary market for mortgages and to ensure competition for Fannie Mae. The establishment of Fannie Mae and Freddie Mac has frequently been cited as the cause for the dramatic increase of homeownership in America from 43% in 1940 to over 70% today.

Despite the fact that a significant amount of the mortgages now owned or insured by Fannie Mae and Freddie Mac are traditionally safe prime mortgages, these two public entities lost a combined $5.1 billion in 2007 and $2.4 billion in the first quarter of 2008 amid struggling housing and financial industries. This rapid depletion of reserves comes at a time when it has become increasingly difficult to sell mortgage-backed securities to investors to replenish Fannie and Freddie’s financial reserve cushion. As a result, Fannie and Freddie’s stock values were allowed to plummet to levels that ultimately forced the federal government to again become intimately involved with the GSEs by placing them into conservatorship and infusing them with billions of dollars to keep them operating.

The Impact on Wall Street

So how did Fannie and Freddie’s failures contribute to our country’s current financial condition? With 2008 being an election year, it became common practice to levy all blame for the United State’s economic problems on the nation’s president for the last eight years. However, many of the fiscal woes that have plagued both Wall Street and Main Street originated before the Bush administration ever moved into the White House. In fact, it was in as early as 1999 that the Clinton Administration openly urged the Federal National Mortgage Association (aka “Fannie Mae”) to reduce down payment and credit requirements for sub-prime or “at risk” borrowers in what was thought to be a valiant attempt to increase home ownership rates among minorities and low-income consumers.

In an amazingly prophetic article written by Steven A. Holmes of The New York Times when Fannie Mae began purchasing sub-prime mortgages in 1999, Mr. Holmes explained that “Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But . . . may run into trouble in an economic downturn prompting a government rescue.” Holmes further explained “If they fail, the government will have to step up and bail them out.” In subsequent years, members of the United States Congress did not head the warnings of many critics like Holmes and actually took further steps to further loosen borrower qualification requirements for loans purchased by the GSEs.

Once the housing bubble began to burst in 2005 and 2006, home prices started declining and by late 2007 the United States’ economy as a whole began to decline. With so much attention directed at slumping housing and stock values, it is easy to forget that this fiscal contraction began with the sub-prime mortgage crisis that has turned Wall Street into a house of cards that seemingly shed portions of its structure on a weekly basis. Even enormous public investment houses and banks like Bear Stearns, Lehman Brothers, A.I.G., Washington Mutual and Wachovia have all required government intervention that has cost tax payers hundreds of billions of dollars to date. Despite continuous public outcries condemning the “Wall Street Fat Cats”, it is difficult to blame these failed companies that either originated these sub-prime mortgages that conformed to Fannie Mae and Freddie Mac requirements or purchased or insured supposedly sound mortgage-backed securities from these GSEs.

Specifically, banks like Washington Mutual and Wachovia originated loans to sub-prime borrowers according to GSE conforming loan requirements before selling these mortgages on the secondary loan market to Fannie Mae and Freddie Mac. Investment banks such as Bear Stearns and Lehman Brothers then assisted the GSEs by pooling these mortgages together to attempt to diversify risk, thereby creating collateralized debt obligations called mortgage-backed securities that were sold to institutional investors. Companies like A.I.G. provided credit-default swaps (“CDS”) that acted like insurance for institutional investors that purchased the mortgage-backed securities to protect them from defaults by the original borrowers.

It is critical to remember that before the sub-prime loan defaults escalated far beyond generally anticipated levels that caused the house of cards to start falling, the companies originating, purchasing and insuring these loans and securities were operating under the assumption that they were working with relatively safe loans that conformed to the requirements of government sponsored entities. It is unfortunate that it was these very requirements that were relaxed, which formed the unstable foundation upon which all of the cards ultimately fell.

Repercussions on Main Street

Many have conveniently attributed the multitude of foreclosed homes now emerging in most residential neighborhoods across the country to the widespread financial irresponsibility of borrowers. These borrowers were supposedly all careless spendthrifts that leveraged large principal amounts against their homes at terms that they later could not afford to repay. These sub-prime borrowers were often financing their properties with short-term, negative amortization, and/or adjustable rate loans that re-set at higher rates after just a few years. When home prices suddenly decreased in value as homeowners’ loan payments escalated to costly amounts, these borrowers could not sell or even re-finance their homes as they soon owed more than their property was worth. Accordingly, these borrowers went into default in mass and ultimately created the first wave of foreclosures across the country. As these foreclosed homes came back up for sale by lenders at below-market prices, comparable housing values started to significantly decline at a historically abnormal pace.

Although it is easy to simply lay a blanket of blame for the foreclosure epidemic upon all of the borrowers that let their homes go into default, it is not entirely justified. The impact of the resulting decline in home values has been felt by any homeowner that was forced to sell or re-finance - not just sub-prime borrowers.

Foreclosures frequently occur as a result of unanticipated circumstances where no fault can be attributed to the borrower. Many fiscally responsible individuals purchased homes in accordance with the generally accepted principal that it is better to purchase rather than throw rent money away each month. However, the recent decrease in home prices has left borrowers who are forced to sell their homes with the dilemma of paying unattainable sums of money to pay off their existing loan balances. Some common examples that can unexpectedly cause the sale of a home include: death of a family member, divorce, job transfer, loss of job, serious illness of a family member, debilitating injury, or a number of other changes in personal finances resulting from a struggling economy. These instances can certainly be experienced by anyone, even the most fiscally regimented, and generally do not result from a lack of personal responsibility.

In order to prevent recent economic woes from reoccurring in the future, the problems in the financial industry must be addressed by both the government and the private sector. The most significant lack of responsibility would truly be realized if both the government and the general public failed to take the necessary steps to prevent recent circumstances from surfacing again in the future.