Time for comrade Paulson to pull the plug on the Fannie and Freddie charade

Are Fannie Mae and Freddie Mac adequately capitalised, as asserted recently by US Treasury Secretary Hank Paulson, Federal Reserve Board Chairman Ben Bernanke and their regulator Office of Federal Housing Enterprise Oversight Director James B. Lockhart III? The answer is: obviously not, if these two government-sponsored enterprises of the US federal government had to make a living on normal private commercial terms. Obviously not if they were subject to the market discipline preached by Paulson and Bernanke, but not practiced when it comes to large financial institutions perceived as systemically important (too large or too interconnected to fail) or too politically sensitive to fail.

The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) are government-sponsored enterprises of the US federal government. They are shareholder-owned corporations authorized to make loans and loan guarantees. Fannie Mae was founded as a government agency in 1938 as part of Franklin Delano Roosevelt’s New Deal. For the next 30 years, it held a virtual monopoly on the secondary mortgage market in the United States.

In 1968, to remove Fannie Mae from the federal budget and balance sheet – the financial demands of the Vietnam War made such financial window dressing politically necessary – Fannie Mae was converted into a private corporation and listed on the stock exchange. It also ceased to be the guarantor of government-issued mortgages. That responsibility was transferred to another GSE, the newly created Government National Mortgage Association (Ginnie Mae). Freddie Mac was created in 1970 to do effectively the same thing as Fannie Mae, that is to expand the secondary market for mortgages. The GSEs buy mortgages on the secondary market, pool them and sell them as mortgage-backed securities to investors on the open market. They institutionalised and popularlised securitisation, a development whose excesses ultimately brought us the subprime residential mortgage backed securities disaster (although the GSEs themselves did not issue or guarantee subprime mortgages).

The US has, starting with FDR, socialised much of its residential housing finance arrangements since the 1930s. Since the recent financial crisis began in August 2007, most of what remained private has also been socialised.

Together, Fannie Mae and Freddie Mac own or back about half of all outstanding home loans. Evidently impressed by the argument that farmers in the US don’t have their snouts deep enough in the public trough, the federal government in 1988 created the Federal Agricultural Mortgage Corporation (Farmer Mac), following the Fannie & Freddie model, as a a stockholder-owned, publicly-traded company to promote a secondary market in agricultural loans. In addition, the Federal Home Association, a branch of the federal Department of Housing and Urban Development, provides subsidised mortgage insurance. Currently the FHA has 4.8 million insured single-family mortgages and 13,000 insured multifamily projects in its portfolio. In addition, the 12 Federal Home Loan Banks (created in 1932) provide low-cost funding to private American financial institutions for home mortgage loans, small business , rural, agricultural and economic development lending. While they are owned by their (private institutional) members, they are exempt from state and local income taxes. They also don’t seem to go broke a lot. An agricultural version of the FHLB, the Farm Credit System, consisting of four Farm Credit Banks, one Agricultural Credit Bank and a number of other institutions rounds off the universe of federally subsidised public housing finance provision in the US.

Formally, neither Fannie nor Freddie are backed or funded by the U.S. government, nor do the securities it issues benefit from any statutory government guarantee or protection. However, the companies’ charters give the Treasury the authority to buy as much as $2.25 billion in each of their securities in the event of possible default. Irrespective of these legal niceties, de facto, everybody knows that, although the shareholders of these GSEs are (probably) not underwritten by the Federal Government, the Federal Government would bail out the rest of the creditors to both institutions before you could say the words “serious threat to residential mortgage finance”. The creditors to Fannie and Freddie are therefore not unduly worried, even as the shares of the two companies have tanked. Between May 1 and July 9, credit-default swaps tied to the senior debt of Fannie Mae and Freddie Mac climbed 35 basis points to 70 basis. That’s ludicrously low, if there is no implicit guarantee of federal financial support for these entities.

During good times, Freddie Mac and Fannie Mae have been able to collect massive rents by being able to borrow at spreads over Federal borrowing rates that were much lower than was warranted by the quality of their portfolios. The implicit guarantee of the Federal Government, an implicit contingent liability of the tax payers, made this possible. These rents were partly appropriated by the orginal investors in Fannie and Freddie stock, and partly by the management and employees of the two GSEs.

Now that the seven fat years have come and gone and the seven lean years have arrived, the Federal Government is likely to be called upon to bail out Fannie and Freddie. The deterioration in the quality of their balance sheet and the increase in the scale of their balance sheets – both the result of political pressure to ‘do something’ about the US housing crisis and the implosion and disappearance of the private home loan market – probably would have pushed both GSEs into insolvency by now had they been honest private corporations. These parrots are no more.

On July 11, 2008, the New York Times reported that US government officials were considering a plan for the US government to take over Fannie Mae and/or Freddie Mac if their financial situations were to worsen due to the US housing crisis. These government officials were also reported by the New York Times as stating that the government had also considered calling for an explicit federal government guarantee of $5 trillion on debt owned or guaranteed by the two companies through legislation. You can see why the creditors to these GSEs don’t seem to be too worried.

There are many forms of socialism. The version practiced in the US is the most deceitful one I know. An honest, courageous socialist government would say: this is a worthwhile social purpose (financing home ownership, helping my friends on Wall Street); therefore I am going to subsidize it; and here are the additional taxes (or cuts in other public spending) to finance it.

Instead the dishonest, spineless socialist policy makers in successive Democratic and Republican admininstrations have systematically tried to hide both the subsidies and size and distribution of the incremental fiscal burden associated with the provision of these subsidies, behind an endless array of opaque arrangements and institutions. Off-balance-sheet vehicles and off-budget financing were the bread and butter of the US federal government long before they became popular in Wall Street and the City of London.

The abuse of the Fed as a quasi-fiscal agent of the federal government in the rescue of Bear Stearns is without precedent, and quite possibly without legal justification. The creation of the Delaware SPV that houses $30 billion worth of the most toxic waste from the Bear Stearns balance sheet (with only $1 billion of JP Morgan money standing between the tax payer and the likely losses on the $29 billion committed by the Fed to fund the SPV on a non-recourse basis) is the clearest example of quasi-fiscal obfuscation I have come across in an advanced industrial country. The decision by the Fed to ‘invite’ the primary dealers and their clearers to collude in the (over) pricing of illiquid collateral offered by the primary dealers to the Fed at the newly created TSLF and PDCF (by the Fed accepting the pricing/valuation by the clearers of the illiquid collateral) is another example of the abuse of the Fed as a vehicle for channeling taxpayer-financed subsidies to the primary dealers. This form of socialism for the rich is therefore well-established.

The chair of the Senate Banking Committee, Chris Dodd, has said the Fed and the Treasury were considering opening the Fed’s discount window to Fannie and Freddie. I am afraid he may be right. After all, an injection of the liquidity by the Fed is so much more politically expedient than an explicit fiscal subsidy, even though their economic effect is identical. This would not be a liquidity enhancement operation by the Fed, which would be a legitimate operation for the central bank to engage in. It would be a quasi-fiscal recapitalisation of two insolvent institutions, which is not part of the mandate of the Fed.

The financial assistance offered to US homeowners through the spagetti of federal financial inducements (ranging from the tax deductability of nominal interest payments to the subsidisation of mortgage financing provided by the FHA and the GSEs) is not primarily socialism for the rich. It is socialism for the electorally sensitive, rather like the agricultural welfare state that exists in the US.

So let’s call a spade a bloody shovel: nationalise Freddie Mac and Fannie Mae. They should never have been privatised in the first place. Cost the exercise. Increase taxes or cut other public spending to finance the exercise. But stop pretending. Stop lying about the financial viability of institutions designed to hand out subsidies to favoured constituencies. These GSEs were designed to make losses. They are expected to make losses. If they don’t make losses they are not serving their political purpose.

So I call on Secretary Paulson, Chairman Bernanke and Director Lockhart to drop the market-friendly fig-leaf. Be a socialist and proud of it. Come out of the red closet. The Soviet Union may have collapsed, but the cause of socialism is alive and well in the USA. Granted, the US version of socialism is imperfect thus far. The federal authorities have mainly intervened to socialise the losses in the financial sector while allowing the profits to continue to be drained off into selected private pockets. But that is bound to be an oversight. It surely cannot be the intention of such committed Marxists to target taxpayer-funded largesse solely at the very rich and at a few favoured, electorally sensitive constituencies. Fannie and Freddie are, or will be, safe in the hands of comrades Paulson, Bernanke and Lockhart.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website