The Financial Crisis, Part III: Know the Basics

"Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in the financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth, from family budgets to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today."
-- Treasury Secretary Henry Paulson Jr., September 8, 2008

Today, the daddy is reflecting on an argument he had last night with a friend-- a black friend too-- and Republican who argued that we got into the present financial crisis by organizations like ACORN pushing the governmental agencies like Freddie Mac and Fannie Mae to purchase mortgages that poor people couldn't afford. The argument got heavy. I told him this was pure non-sense presented by idiotic Republican ideologues like Rush Limbaugh attempting excuse the failure of Reganamomics (tax cuts to the rich, de-regulations to the max).

But what became clear to the daddy is two things:
1. The daddy and a lot of the rest of us need to know more about the basics of this crisis. And, to do this, we need to go back to Fannie Mae and Freddie Mac, which is where this financial crisis has its genesis.
2. If we knew the basics behind the crisis, that is, the functions of these institutions, the regulations that Fannie Mae and Freddie Mac executives worked with congressional members to get rid of or circumvent and the risks they decided to take on their own for short-term profits, we would have a better idea about solutions that the government need to take to get us out of the present financial crisis.

Like many of us, my friend not only didn't understand clearly the function of Freddie Mae and Fannie Mac, he didn't know that they were private and were not susceptible to some governmental restrictions (which suggests the need for greater governmental oversight), and that it made decisions on its own to purchase risky mortgages with little or no oversight from the government.

This article states clearly that Fannie Mae and Freddie Mac were essentially non-competitive, corporate, welfare institutions, receiving 2 billion from the government off the top, catering to middle income and upper-income borrowers.

Note: This article was not written by some "wild-eyed radical," as he would say, but a member of the Cato Institute, a conservative think tank.

Freddie Mac and Fannie Mae: Corporate Welfare King & Queen

by Vern McKinley

McKinley has worked as a financial analyst and attorney in Washington, D.C. This article is based on a policy analysis published by the Cato Institute.

They are two of the largest financial institutions in the nation, with more than half a trillion dollars in assets between them: Freddie Mac and Fannie Mae. But few people can explain exactly what function those financial giants serve.

Freddie Mac and Fannie Mae indirectly assist homebuyers by purchasing mortgages from lenders, such as commercial banks, savings and loans and mortgage banks. Freddie and Fannie, in turn, generally get those loans off their books by creating securities that are eventually paid off as the underlying mortgages are paid off. Homeowners are happy because they are aided in borrowing money for a home. Lenders are happy because they don't have to hold mortgages for several years. Investors in the securities are happy because they have a reliable investment, and Freddie Mac and Fannie Mae are happy because they make a handsome profit. Sound like capitalism at its finest? Not exactly.

Although Freddie and Fannie are privately owned, they are what is known as government-sponsored enterprises (GSEs). GSEs don't have to follow all the rules that true privately owned companies do: they don't have to register their securities with the government, their securities receive special treatment for investment purposes, they don't have to pay state and local income taxes and--most important--their government sponsorship gives them the aura of a fully guaranteed government entity. That final benefit means they save billions in borrowing costs, just as lenders are willing to offer low-interest student loans that are guaranteed by the government. That savings alone allows the GSEs to pocket about $2 billion per year, according to estimates by the Congressional Budget Office and the Treasury Department.

Allowing Congress to grant such special privileges is a bad idea. Those privileges, which are granted solely to Freddie and Fannie, crowd out other potential competitors in their market. Privately owned companies should not receive such preferred borrowing status, because it redirects investor funds into the middle- and upper-income housing market at the expense of other potential investments. Finally, the failure of either Freddie or Fannie could saddle taxpayers with a huge liability.

Throughout 1996, a number of reports mandated by recent legislation were issued by the General Accounting Office, the Congressional Budget Office, the Department of Housing and the Treasury Department. Those reports scrutinized the system under which Freddie and Fannie operate. Congressional hearings were also held on the subject. Critical commentators argued that the $2 billion in benefits received by the GSEs is a blatant form of corporate welfare. They further argued that Freddie and Fannie constitute a duopoly, a fancy term to indicate that the two GSEs share above-average profits in a noncompetitive market. It's no wonder that with the many benefits of their special status, Freddie and Fannie have no direct competition. They have even begun to move into new markets.

A clear sign of how much Freddie and Fannie value their government sponsorship is the great effort they expend to maintain it. They have used a portion of their billions of dollars in benefits to fund a high-powered public relations and lobbying machine with the sole purpose of maintaining their current status. Their efforts have involved spending millions on full-time lobbyists, paying millions to politically connected executive officers, and making "soft money" political contributions of three-quarters of a billion dollars, evenly split between Democrats and Republicans, during the last election cycle.

One would think that the scrutiny of last year's reports and hearings would have prompted the GSEs to lie low for a while, but that has not been the case. They have continued to squeeze competitors who do not enjoy their borrowing and tax advantages by entering or increasing their presence in the insurance, reverse mortgage, home equity and subprime mortgage markets. They have contributed nearly $400,000 in soft money in just the first six months of this year. Finally, Fannie Mae brought on board a new political hired gun: Jamie Gorelick, Janet Reno's second-in-command at the Justice Department. She will be compensated millions to, as the American Banker put it, "fight for Fannie Mae on Capitol Hill."

The GSE structure is a classic case of a special legislative benefit that its recipients will fight to the death to maintain. Congress should immediately revoke all the benefits of government sponsorship: clearly, Freddie and Fannie can be profitable without them. Eliminating special privileges will force mortgage markets to be truly competitive and will eliminate the possibility that the current system of government sponsorship will someday lead to yet another taxpayer-funded bailout.

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Note: On September 7, 2008, Treasury Secretary Henry Paulson, Jr. announced the bailout of mortgage giants Fannie Mae and Freddie Mac. They were put into receivorship, which could cost taxpayers billions of dollars. Together, Fannie Mae and Freddie Mac Together own or guarantee just under half of the country’s $12 trillion in mortgage debt.