Tom Heintjes: Welcome to another Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine. Today, we're joined by Scott Frame, a financial economist and senior policy adviser with the Atlanta Fed. Scott recently wrote a working paper about the government's conservatorship of Fannie Mae and Freddie Mac, which is, appropriately, titled "The Rescue of Fannie Mae and Freddie Mac," and Scott has agreed to sit down with us to discuss it. Scott, thanks for joining us.
Scott Frame: Thanks for having me, Tom.
Heintjes: Scott, I'd like to start out by getting you to briefly describe the roles of Fannie Mae and Freddie Mac in the U.S. housing finance system.
Frame: Well, Tom, Fannie Mae and Freddie Mac actually play a very large role in that system. They help it to finance about one-half of our $10 trillion in residential mortgage debt outstanding. The two firms do this in what we call the "secondary conforming mortgage market," which means they cannot lend money directly to households—that's the secondary market part of things—nor can they deal in mortgages above a certain size.
Heintjes: Can you tell me what their two principal business lines are?
Frame: Yes. In the first business line they issue credit guarantees on pools of loans that are sold to them by mortgage originators. This is commonly referred to as securitization, and it results in what people refer to as agency mortgage-backed securities. Their second business line involves portfolio investment of mortgage assets on their own balance sheets, which they in turn then fund with what is referred to as agency debt.
Heintjes: Scott, let me step back into history a little bit and talk about Congress, which created Fannie and Freddie to promote access to mortgage credit, which many would say is of course a laudable goal. But in your paper you say that the agencies were—and I quote you—"destined to fail." What shaped your thinking on that point?
Frame: Well, Tom, our comment about the two firms being destined to fail is really reflective of their organizational structures. Congress created Fannie Mae and Freddie Mac to enhance the stability and liquidity of U.S. mortgage markets. And to that end, their charters provided them with several benefits that led to the widespread belief in capital markets that their obligations were implicitly backstopped by the U.S. government. This created a significant cost advantage for the two firms.
Heintjes: Was that kind of a wink-wink relationship or belief?
Frame: It was, because by law the obligations of the two firms were to expressly have on them that they were not obligations of the U.S. government, but there were a large number of provisions in their charters that nonetheless led to this market perception, as well as a lot of movement between individuals in government then moving to these firms, and then being able to talk to outside investors about what the real deal was.
Frame: Now, congressional intent, here, was that the two firms would take these competitive advantages, and they would then pass on any cost savings to mortgage borrowers, basically allowing for a housing finance subsidy that wouldn't be recorded on the government's books. So from a politician's perspective this is sort of like a free lunch. You get to provide a benefit to some set of constituents without actually having to say that you spent any money doing so.
Heintjes: And as an economist you know, of course, that there is no free lunch.
Frame: There is no free lunch, Tom, that's exactly right. The reality was that the subsidy…so there were cost advantages given to Fannie Mae and Freddie Mac. They did not pass on all this benefit to borrowers. Their shareholders captured a significant amount of it. Some of it did pass through for borrowers.
Now, Fannie and Freddie were publicly traded companies. Up until the time they failed, their shares were listed on the New York Stock Exchange. They were publicly traded companies, and as such, they were profit-maximizing companies and they principally answered to their shareholders, and really, frankly viewed their public mission as simply a cost of doing business. Now, allowing a profit-maximizing firm access to government credit can create some very strong risk-taking incentives, and this can be especially the case when the compensation of senior management is very generous and largely tied to earnings and share prices.
So, for many economists that sort of study this problem, we understood the skewed incentives. In this particular case with Fannie Mae and Freddie Mac, the Congress established a purposefully weak regulatory regime, including very low capital requirements. And of course these firms, by being chartered to serve the housing finance sector, were not diversified in that way in the types of credit instruments that they would manage in their portfolios. They really had this singular exposure to real estate. For these reasons, taken together, some of us viewed Fannie Mae and Freddie Mac as destined to fail.
Heintjes: Right, now I understand that assertion. Scott, let's step back to 2008, when the housing crisis was in full swing and the extent of Fannie and Freddie's exposure to the mortgage market became apparent. What happened at that point?
Frame: Well, Tom, the housing crisis at its core was really about falling house prices. In situations in which homeowners find themselves in a position of what we call negative equity, or having a higher mortgage balance than the value of the home, the homeowners' incentive to default on their mortgage are greatly heightened. Typically, home buyers don't default on their mortgage simply for this reason, but if there is some other trigger that occurs in their life—a job loss, a divorce, things like that—and they're in a situation where the home is worth less than the mortgage balance, it becomes much easier for them to stop paying on the mortgage and walk away. So that's sort of a backdrop of what was going on beginning in 2007. By 2008, housing prices had been falling for over a year, and mortgage defaults had been rapidly rising. And this led forward-looking market participants like shareholders and creditors of Fannie Mae and Freddie Mac to become very concerned about the financial condition of the two firms and, more importantly, whether the federal government would make good on its implicit promises to protect the holders of agency debt and agency mortgage-backed securities.
During this time, Fannie Mae and Freddie Mac saw their share prices crash and their funding costs rise. This created a lot of uncertainty in financial markets during the summer of 2008. And in July of that year, the government responded first to these issues by passing a law known as the Housing and Economic Recovery Act, and an important provision of this law gave the U.S. Treasury temporary but unlimited authority to invest in Fannie Mae and Freddie Mac.
Heintjes: A few months after that, in September 2008, the government placed Fannie and Freddie into conservatorship. In the short term, what was the effect of conservatorship?
Frame: Well, the newly created regulatory body for Fannie Mae and Freddie Mac—something known as the Federal Housing Finance Agency, and that's with us today—that agency was created out of the Housing and Economic Recovery Act. They placed the two firms into conservatorship, and this meant that the regulator was assuming the responsibility of the directors, the officers, and the shareholders of both firms with the purpose of conserving their assets and rehabilitating them into safe and sound condition. Now, importantly, the Federal Housing Finance Agency 's actions were accompanied by a large financing commitment from the Treasury through preferred stock purchase agreements. These agreements ultimately injected $200 billion into Fannie Mae and Freddie Mac. I provide that as sort of background.
Heintjes: And what was Treasury seeking to do with this action?
Frame: They were attempting to assuage the concerns of the creditors of Fannie Mae and Freddie Mac, both in their debt securities as well as holders of mortgage backed securities. And so, to take that forward in terms of what was the short-term effect of conservatorship, the goal was really to maintain the flow of credit into mortgage markets, and also to honor the implicit promises that the U.S. government had made to holders of agency debt and mortgage-backed securities. So it was really about stabilizing markets, having a very substantial commitment, or backstop, behind the two firms that allowed the capital markets to understand that the government was not going to allow these two entities to fail.
Heintjes: What would have been the effect of a lack of confidence in Fannie Mae and Freddie Mac?
Frame: I think it could have been twofold. Again, the government at that time was trying to maintain capital for the mortgage market, and there was a grave concern that if Fannie and Freddie were allowed to fail that mortgage credit supply could dry up, and this could significantly exacerbate the housing downturn to where it would have been much worse than even we experienced. Which was bad enough.
The second part was that there was a lot of existing obligations out there. As I mentioned at the outset, Fannie Mae and Freddie Mac managed about $5 trillion in home mortgage debt, or they helped to finance that. Their obligations are then in turn held by leveraged investors, a lot of commercial banks—the investors that were already facing financial difficulties themselves at that time. So the idea of doing nothing to assist Fannie Mae and Freddie Mac was just too daunting, because it would have just created much greater uncertainty and the potential for chaos at that point in time, in late 2008.
Heintjes: Right. I guess you would say they're just too large and interconnected to be allowed to fail?
Frame: That's right, that's right. And I would say, as an aside, I talked about commercial banks being significant investors——both U.S. banks and foreign banks—being significant investors in Fannie Mae and Freddie Mac. Another consideration was that almost $1 trillion of these obligations were held by foreign investors, particularly the central banks of China and Japan. So losses to these investors would have risked certainly a significant international incident and may have even undermined confidence in the U.S. government.
Heintjes: Conservatorship is obviously a dramatic step, but besides conservatorship, what options were available to the government?
Frame: Well, in terms of other resolution options, the Federal Housing Finance Agency could have used their new receivership authority—this was an authority that the FDIC [Federal Deposit Insurance Corporation] has to deal with failed banks. It was only given to the Federal Housing Finance Agency in the summer of 2008 as part of the Housing and Economic Recovery Act.
Now, receivership would have allowed for the restructuring of Fannie Mae and Freddie Mac, but it also would have then released the firms to private ownership and end their existing form. And two important reasons, I think, why the government did not select the receivership option was that through the lens of the fall of 2008, it was very unclear what the future path of house prices was going to be. And there was a real risk that if you released the two firms after restructuring, they may even fail again, and therefore you wouldn't have actually solved one of the important near-term issues.
The second [part] was that the business models of Fannie Mae and Freddie Mac—if you recall back to when we were discussing our comment about being destined to fail—these discussions and concerns had been on people's radar in Washington for five or six years, being debated, being discussed. And I think there was a feeling by policymakers that this conservatorship option would create sort of a time-out and instead of releasing the firms back out into the marketplace in their existing form, that maybe they should sort of be set aside, put in a time-out and then give the Congress an opportunity to re-evaluate the structure of those two firms.
Heintjes: Right. Now, we've already mentioned that a conservatorship was a drastic but necessary step to take. Was something perhaps even more drastic, like nationalization, considered?
Frame: Well, that's right, Tom. I don't think it was seriously considered, but you would have to lump it in there as an alternative. As I mentioned, the Treasury had this temporary but unlimited investment authority. They could have, through some process, attempted to take a controlling interest in the stocks of both Fannie Mae and Freddie Mac and effectively nationalized the firms and run their operations. One of the political constraints on such an approach—I think the term "nationalization" itself is sort of a loaded term, and I think it makes people anxious. And I think the other political issue is that once that controlling interest was taken, the federal government would have likely been compelled to have to bring Fannie Mae and Freddie Mac onto the government budget. That would have, again, created another optics issue about the national debt jumping by, say, $5 trillion.
Heintjes: Also something that arouses some passion.
Heintjes: Conservatorship was envisioned as a short-term fix, but here we are talking about it six years later. In your paper, you note that starting the conservatorship has proven to be easier than ending it. Is there a consensus about what a postconservatorship Fannie and Freddie might look like?
Frame: No, and this is the problem. To just give you sort of the lay of the land in Washington: there are different pieces of legislation that have been floating around in the last two or three years related to this topic. I think in the House of Representatives, the Republicans who've controlled the House now for several years; they would frankly like to dissolve Fannie Mae and Freddie Mac and really turn the secondary conforming mortgage market a fully private market.
On the set-up side, there was a pretty strong attempt last year at some bipartisan legislation that would seek to create a government mortgage insurer that would guarantee mortgage-backed securities, on top of guarantees from private securitizers. However, deliberations bogged down around a number of important details related to how to regulate these private securitizers, the fees that the government needed to charge for, insurance, affordable housing mandates, et cetera.
So while on one hand it would seem fairly straightforward to try and have some housing finance reform here, there's a lot of different constituencies and a lot of passionate views out there, so it may be a while.
Heintjes: I guess it depends on how you define "straightforward." Scott, in 2011 the Treasury Department and the Department of Housing and Urban Development issued a white paper recommending that Fannie and Freddie be wound down, but winding down looks unlikely. In your view, is this step needed for achieving meaningful reform?
Frame: I don't think the firms need to be wound down, per se, and when I see or hear the term "wound down" I think about being fully liquidated and eliminated. What I think is critical here is that the two firms' congressional charters be rescinded to the extent that there's value in Fannie Mae and Freddie Mac, without these charters—and I'm fairly certain there is—they could potentially reconfigure themselves as, for example, mortgage insurance companies, and play a role in the future housing finance system as private market actors. So I don't think they necessarily need to be wound down.
Heintjes: I hope you don't mind if I ask you to take out your crystal ball for a moment, and look ahead: what implications do you think the conservatorship and its eventual end have for the U.S. housing market?
Frame: Well, I'll actually answer this in a couple of ways; in terms of the immediate effects of conservatorship, I think in the post-conservatorship period, we've seen a situation where Fannie Mae and Freddie Mac have tightened up their underwriting standards in an effort to have what I might refer to as sustainable home-ownership situations. So the most risky lending has been curtailed, there's been a little bit more of a push for trying to charge fees for insurance or insurance premiums that are a little better aligned with the risk of the underlying loans.
Of course, these changes have probably on the margin curtailed mortgage credit supply; but nevertheless, if Fannie and Freddie had not been there through he Great Recession there would have been much, much less credit available than had otherwise been the case.
In terms of the end of conservatorship; whether we actually need a government guarantee for mortgage securities is something that's been a part of the central debate about housing finance reform and the future of Fannie Mae and Freddie Mac.
Heintjes: What is your sense of how the discussion has gone?
Frame: My sense is economists are perhaps more divided on this issue actually than market participants who see a substantial role for government in the mortgage market. There's a pretty good consensus there amongst housing and mortgage market participants. Now, I have a personal opinion, but I've really tried to focus a lot of my research on trying to educate policymakers by trying to explain the costs and the benefits of such widespread government involvement in housing finance, as well as the economics of how different specific proposals may lead to different risk migration outcomes in capital markets, and also helping them to understand what the overall risk to taxpayers could be.
Heintjes: When the conservatorship happened, did you think that we would still be talking about it in its current state now, after six years?
Frame: No, I honestly thought—and I think everyone involved with the conservatorship decision thought—that housing finance reform would have passed by now. Unfortunately I don't see the next opportunity coming until after the next presidential election.
Heintjes: Right. Scott, in preparing to talk to you today I was looking over some of your older research and I was reminded that you've been sounding warnings about Fannie and Freddie for several years prior to their failure, so it's clear that you're among the people who first saw how this might play out—how it did play out, as we now see. I don't want to give you an opportunity to say "I told you so" because I know you're too magnanimous for that and you take no satisfaction in how things developed. But why do you think that a foreseeable problem was not remedied before it became a full-blown crisis?
Frame: Well, that's really kind, Tom; and, as you say, I take no pleasure from this episode in financial history. But to simply answer your question, it's the politics of housing. And these politics emanate from both sides of the aisle; it created this problem and it also led to inaction. Really, I fear, that the same process will not allow for any meaningful reform and thereby lay the groundwork for our next crisis, I'm sorry to say.
Heintjes: I guess we'll end on that somewhat less-than-cheerful note. I should also note that we have a link to Scott's paper on our website, frbatlanta.org; it's a very accessible look at Fannie and Freddie and the environment that led to where we are today, and I encourage you to give it a read.
Scott, thanks so much for being with us today and sharing your thoughts.
Frame: Thank you for having me, Tom.
Heintjes: And that's it for this Economy Matters podcast. Join us next month when we'll talk to Melinda Pitts, an Atlanta Fed staff economist, about her research into the relationship between the minimum wage and youth rates of drinking and driving. Is there a relationship? You'll have to join us to find out.