A number, like a picture, can be worth 1,000 words. In England, 1066 means the Norman Conquest. The world over, 3.14159 screams pi.
For Fannie Mae and Freddie Mac, the figure to remember is 79.9 -- the percent ownership that the U.S. Treasury took in each when it seized control in 2008. If the stakes were 80 percent, the mortgage companies would land on the federal budget, as we’re reminded in “Guaranteed to Fail,” a valuable book on how two quasi-public companies became “the world’s largest and most leveraged hedge funds.”
Kiss all the political posturing about the U.S. public debt ceiling goodbye: With Fannie Mae and Freddie Mac’s debts tacked on, the total would lurch to $15.84 trillion, well over the current limit of $14.29 trillion, the authors say.
Books written by committee usually leave me cold. This one, by four professors at New York University’s Stern School of Business, is different. A balanced study, it rises above a clash between partisans on the right -- who call the companies “ground zero” in the meltdown -- and those on the left who blame deregulation and Wall Street excess.
“There is probably a little truth to both views,” the authors say. “But these arguments are beside the point.”
For decades, Democratic and Republican presidents alike have used housing subsidies as a cynical tool for combating ever-rising income inequality with easy credit. “Let them eat credit,” as economist Raghuram G. Rajan jokes.
The Obama administration is proposing to wind down Fannie Mae and Freddie Mac, making the timing for this book -- by Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence J. White -- opportune. Part primer, part policy prescription, the text explains in simple language what these entities are, how they got so big, and why we must fix them.
Fannie Mae and Freddie Mac were once a fairly minor presence in residential mortgages. As publicly traded companies, though, they expanded their market share, from 4.4 percent in 1970 to 41.3 percent at the time the financial crisis hit, the authors say.
By then, the two government-sponsored enterprises, or GSEs, held combined mortgage portfolios of $1.43 trillion plus $3.5 trillion in guarantees on mortgage-backed securities. They had morphed into Godzilla hedge funds with government backing, the authors say.
Who needs such monsters? Many countries with far less government involvement in mortgages enjoy comparable home ownership rates and affordable housing, they show.
Fannie Mae and Freddie Mac’s growth reflected astonishing advantages they had over private rivals. They paid lower taxes, could borrow at cheaper rates and were required to hold less capital. How much less? When they guaranteed the credit risk of mortgage-backed securities, or MBS, the capital requirement was 0.45 percent -- just 45 cents per $100 of guarantees, the authors say; when they invested such securities, the buffer was 2.5 percent, or $2.50 per $100.
A federally insured bank, by contrast, faced a capital requirement of 4 percent for holding residential mortgages -- unless it held GSE MBS. In that case, the requirement fell to 1.6 percent, creating perverse incentives for banks to originate mortgages, sell them to the GSEs for securitization and buy them back as GSE MBS. Same risk, less capital.
A race to the bottom was on -- a competition to churn out increasingly dicey mortgages -- only now it pitted Godzilla Fannie Mae and Freddie Mac against King Kong banks deemed to have “a too-big-to-fail government guarantee,” the authors say. Here was “a highly leveraged bet on the mortgage market by firms that were implicitly backed by the government with artificially low funding rates.” America, the bastion of free markets, became anything but when it came to mortgages.
Once Fannie Mae and Freddie Mac collapsed, the Federal Reserve stepped into the breach by purchasing more than $1.4 trillion in GSE debt and mortgage-backed securities. This marked the Fed’s biggest foray during the crisis, the authors say -- far bigger than its role in the rescues of Bear Stearns Cos., American International Group Inc. (AIG) and Citigroup Inc.
It also created a conflict of interest, they say: If the Fed at some point needs to raise rates to head off rising prices, it would harm the value of the securities on its own balance sheet. Given how the public and politicians might perceive losses, the Fed could be tempted to let inflation grow.
Ultimately, the only solution for the two mortgage companies is to wind them down, the authors say. For starters, they should stop investing in mortgage assets: Their $1.71 trillion portfolio could be gradually liquidated through a “bad bank” resembling the Resolution Trust Corp., the agency that mopped up after the savings-and-loan crisis in the late 1980s and early 1990s.
That leaves the trickier question of what to do about Fannie Mae and Freddie Mac’s second main function -- to guarantee mortgages against default. Here, the authors conclude that the insurance should be preserved through a public-private partnership in which private insurers would decide which guarantees to provide, price them and insure a slice of the total, say 25 percent. The government would cover the rest.
This proposal gives me pause. Taken as a whole, “Guaranteed to Fail” suggests that public and private parties rarely consort without making secret accords at the taxpayer’s expense. Still, the professors argue the case in convincing detail, and one can only admire their pragmatism.
(James Pressley is a book critic for Muse, the arts and leisure section of Bloomberg News. The opinions expressed are his own.)
To contact the writer on the story: James Pressley in Brussels at firstname.lastname@example.org.
To contact the editor responsible for this story: Mark Beech at email@example.com.