Season Investments


Chocolate Sundaes

Posted on August 13, 2013

“This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears.” – Marc Gott, former director at Fannie Mae 

Last week President Obama endorsed a plan being debated in the Senate to “wind down” both Fannie Mae and Freddie Mac, which have been under full government control since the middle of 2008 when they were placed into conservatorship during the heart of the subprime crisis. Government sponsored entities (GSE) like Fannie and Freddie currently underwrite or back 90% of the mortgages here in US, so weaning the market off of these giants will not be easy. The details on how to get from point A (current state) to point B (privately underwritten mortgages) are fuzzy, but free market capitalist are applauding the bi-partisan effort in the Senate and the President for endorsing a plan to take a step in that direction. We will look at some of potential advantages and disadvantages of the proposed Senate bill in next week’s Insight. This week we are going to explore the history of Fannie and Freddie to better understand their role in the economy and how we got to where we are today.

Before the Great Depression of the 1930’s, financing mortgages for the purchase of a home was entirely done by private institutions such as banks, thrifts, and insurance agencies. Home owners were required to put down around half of the money for the purchase in order to get a short-term (1o years or less) loan for the remainder of the purchase price. The pricing on mortgages varied greatly due to each lender’s unique circumstances and willingness to take on the risk of extending credit to would be homeowners. Then the Great Depression hit, unemployment skyrocketed and individuals fell behind on their mortgages. By 1933, the government estimated that 20%-25% of all mortgages in the US were in default.

In response to the Great Depression, President Franklin D. Roosevelt (FDR) instituted the New Deal, which was a collection of initiatives and programs to help restore confidence to the American people. One of the programs that came out of the New Deal was the National Housing Act which established the FHA to offer federally backed insurance for home mortgages. FHA insurance allowed lenders to offload the risk of default on the mortgage, thereby expanding the pool of buyers for which they were willing to underwrite. The FHA was responsible for expanding the use of fixed-rate, long-term mortgages which made housing more affordable for the general public.

In 1938 an amendment to the National Housing Act established Fannie Mae as a government agency with a mandate purchase, sell and hold FHA-insured loans. By purchasing these loans, Fannie Mae was able to free up capital on the balance sheet of a private lender, which would enable them to turn around and put the capital to work by underwriting more mortgages. Fannie Mae operated in this capacity as a fully owned government entity until 1954 when the government turned Fannie Mae into a “mixed-ownership corporation” by offering common equity (e.g. stock) to private investors alongside the government’s preferred equity position in the company. Fannie Mae made the next step to a private corporation in 1968 when President Lyndon B. Johnson decided to spin the entity off of the government balance sheet in response to rising deficits from the Vietnam War. Two years later Freddie Mac was established to create competition for Fannie Mae which had been enjoying a monopoly in the secondary mortgage market. Both Fannie and Freddie became known as “hybrid entities” since they were private, for-profit companies with highly paid executives and stock holders that still had a government established,public mission to make housing more affordable for Americans.

Fannie and Freddie grew like gangbusters over the subsequent decades because of the advantages afforded to them as a quasi-government entity. First off, they were able to leverage their balance sheet to a greater extent than other private companies due to relaxed capital requirement imposed by government regulators. Secondly, they borrow money at lower rates due to the “wink and a nod” backing of the US government behind each entity. Lastly, they kept the profit machine humming along by spending huge amounts of money on lobbying efforts. The Fannie Mae lobbying effort was so strong that it became legendary. Any time there was a congressional hearing on the merits of the GSEs, each congressman would receive a “Fannie pack” which was a list of all the voters in their district with a mortgage owned by Fannie Mae. Bill Maloney, a former chief lobbyist for Fannie Mae who left in 2004, said the Fannie Mae lobbyist had the view that, “If you punch my brother, I’ll burn down your house.”

In 1992 President Bush signed the Housing and Community Development Act of 1992 which amended the charter of Fannie and Freddie to “…have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return.” In other words, the GSEs were to have an explicit charter to make housing more affordable for high risk, lower income families. The initial annual goal was that 30% of all mortgages purchased by Fannie or Freddie be sourced from low to moderate income families; a goal which had increased to 55% by the time the wheels were coming off in 2007.

This new government mandate combined with more competition from investment banks who had developed a way to cut the GSEs out of the equation by bundling mortgages together into a mortgage backed security (MBS) to sell directly to fixed income investors (e.g. pensions, insurance companies, foundations, etc.), meant the GSEs would have to take on more risk in order to keep shareholders happy with increasing profits. Fannie and Freddie were no longer able to control the lending standards of the mortgage market, which led to a decline in underwriting standards. Exotic products such as the Alt-A, no-doc, or negative amortization mortgages became common place. In this new environment, the GSEs had two choices, play ball or become obsolete. They chose the former and started buying the exotic mortgages lenders were falling over each other to write, bundle, and offload to someone else in the form of a MBS. The GSEs were venturing into uncharted territory by trying to “push chocolate sundaes” through a machine that was designed for plain vanilla loans as stated in the opening quote by Marc Gott.

Unfortunately, as everyone already knows, this new venture did not end well. In the summer of 2008 Fannie Mae and Freddie Mac were placed in conservatorship under US government control as the implicit government guarantee became explicit. In a way, the implicit guarantee was a self-fulfilling prophecy which allowed the GSEs to grow to a size that made them too big to fail, backing over $5 trillion in mortgages when they went under government control in 2008. Treasury Secretary Hank Paulsen went on record to state, “Fannie Mae & Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil here at home and around the globe.”

The purchase of Fannie and Freddie has cost taxpayers anywhere from $130 - $317 billion depending on who you ask. Some might argue that this is a high price to pay while others would take the opposite side stating that it was absolutely necessary to ward off a total collapse of the global financial system. The good news is that both Fannie Mae and Freddie Mac have returned to profitability and have repaid most of the money that was advanced to them since being taken over. With the US housing market in full recovery and the GSEs turning out profits, it is very tempting for a politician with a short-term focus (as most unfortunately have) to ignore the underlying dangers of history repeating itself. For this reason, we applaud both the President and the Senate for taking a longer term look at the situation, which is something we will unpack in more detail next week.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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