part9
Fallout: taxpayers pay for Fannie’s and Freddie’s Binge on Risky Mortgages
As long as housing prices continued to rise, the GSEs’ exposure to risky nonprime loans
remained manageable. With the bursting of the bubble, however, the underlying
weaknesses of Fannie Mae and Freddie Mac, caused by years of purchasing low-quality loans and dangerously high levels of leverage, began to show. In 2007, the GSEs reported combined losses of over $5 billion, the first full-year loss for Fannie Mae since 1985 and the first ever for Freddie Mac. These losses were dwarfed in 2008, however, when the GSEs reported combined year-end losses in excess of $108 billion. The companies’ share prices plummeted by 60% between July 2007 and July 2008.82
In response to these mounting losses, Congress finally passed much-needed reform
legislation, the Housing and Economic Recovery Act of 2008 (“HERA”), which was
signed into law on July 30. HERA created a new regulator, the Federal Housing Finance Authority (“FHFA”) to replace OFHEO. Congress gave the new agency the power to review and approve new types of mortgages, set capital requirements, limit the GSEs’ portfolio sizes, and force them to sell assets. FHFA was also granted the power to place Fannie and Freddie into conservatorship and reorganize them in order to prevent their insolvency.
These reforms came too late to protect taxpayers from a huge government bailout. On September 7, 2008, FHFA, in consultation with Treasury Secretary Henry Paulson,
exercised its new authority and placed Fannie Mae and Freddie Mac into conservatorship, wiping out common shareholders and taking on the responsibility for running the companies. In addition to the collapse of the GSEs’ share price and their mounting losses, one of the factors in this decision appears to have been Treasury’s discovery that the GSEs had overstated their capital reserves by $64 billion by relying on government-granted tax credits which they would probably never be able to use and were therefore worthless. Treasury also discovered that the GSEs were not marking losses on their subprime and Alt-A loans to market and were carefully managing their public reporting of these losses.84 Finally, the full extent of the GSEs’ involvement in risky lending had started coming to light. For example, in its 2007 10-K, filed in February 2008, Fannie Mae finally disclosed its large exposure to first mortgages with so-called “silent seconds” – second loans made to cover down payment and closing costs. Freddie Mac divulged its own exposure to such risky mortgages in its second quarter 10-Q filed in August 2008. During the House Oversight and Government Reform Committee’s investigation starting, in the fall of 2008, it became clear that Fannie Mae and Freddie Mac were in fact leaders in risky mortgage lending. According to an analysis presented to the Committee,
between 2002 and 2007, Fannie and Freddie purchased $1.9 trillion of mortgages made to borrowers with credit scores below 660, one of the definitions of “subprime” used by federal banking regulators.85 This represents over 54% of all such mortgages purchased during those years. If one factors in Alt-A and adjustable-rate mortgages, this analysis found that, at the end of 2008, Fannie and Freddie were still exposed to $1.6 trillion of risky default-prone loans. Thus, at year-end 2008, Fannie Mae and Freddie Mac were responsible for 34 percent of all outstanding subprime mortgages and 60 percent of all outstanding Alt-A mortgages in the United States. Fannie and Freddie were not only enabling a huge amount of subprime and Alt-A lending– the extremely high delinquency and default rates on these mortgages demonstrate that
the GSEs were directly damaging both themselves and their borrowers. At year-end
2008, Fannie’s and Freddie’s main line of business by volume continued to be backing
safe mortgage lending, with 66 percent of their exposure consisting of prime loans. As of December 31, 2008, this 66 percent exposure to prime mortgages, even with the
deterioration in the housing market, was only suffering a serious delinquency rate of
about 0.5 percent, accounting for only 10% of the GSEs’ total losses. On the other hand, nonprime loans, which accounted for only 34% of the GSEs’ risk exposure at the end of 2008, were suffering a 6% delinquency rate, accounting for 90% of the GSEs’ losses. Put another way, the GSEs’nonprime loans were 14 times more likely to be in serious delinquency than their prime loans. In the end, failures on nonprime GSE mortgages may account for the failure of roughly 1 in 6 home mortgages in the U.S., or 8.8 million foreclosures.
The continuing losses caused by Fannie and Freddie’s binge on junk mortgages have
already cost the taxpayers dearly. Under the terms of their conservatorship, the U.S.
Treasury is committed to inject up to $400 billion of capital into Fannie and Freddie to
offset their losses and maintain solvency. These capital injections take the form of
Treasury purchases of preferred stock in the companies. As of April 30, 2009, the
Treasury had spent $59.8 billion on such purchases.89 In addition, the Federal Reserve
has also pledged to purchase GSE debt issuances, of which the Fed had bought nearly $77 billion worth as of May 20, 2009.90 Finally, both Treasury and the Fed continue to purchase massive amounts of GSE mortgage-backed securities directly – over $567 billion-worth as of May 20, 2009.91 The sum of these federal aid packages brings the total current taxpayer exposure to GSE liabilities to over $700 billion.
Even more than Wall Street firms, Fannie and Freddie used high leverage to borrow
money and gamble on low-down payment affordable and speculative mortgages. Unlike Wall Street, however, the GSEs did this with the mandate and the blessing of Congress and successive Administrations, which encouraged them to use their government-granted competitive advantages to engage in a race to the bottom, boosting the national homeownership rate for political gain. All told, the government experiment in unsustainable affordable mortgage lending based on low down payments and “flexible” credit criteria has sucked the equity out of the U.S.
housing market, trapped millions of Americans under crushing debt, and seriously
damaged global financial markets. In 2006, the value of U.S. housing was estimated at $22 trillion. By October 31, 2008 this had fallen to $18.5 trillion. As of the end of 2008,
there was about $12 trillion in mortgage debt, of which 42 percent consisted of default-prone loans, with 70 percent of all mortgage debt guaranteed by the federal government. This means that at the end of 2008, the U.S. housing market had a loan-to-value ratio of 66 percent. If U.S. housing prices fall an additional 15 percent to $11 trillion by the end of 2009, the U.S. housing market will be leveraged at a ratio of 110 percent, meaning the market on average will be in negative equity, or “under water.”
These statistics are alarming enough on their own, but the real tragedy of the
government’s affordable housing policy is the impact on average Americans, particularly those of modest means. Millions of these borrowers, who were supposed to have been helped by federal affordable housing policy, have now been forced into delinquency and foreclosure, destroying their asset base, their credit, and in some cases their families. For example, Latino homeowners, who once appeared to be among the most frequent beneficiaries of affordable housing policies, are now the victims of the policies that their political representatives in Washington once championed. According to the Pew Hispanic Center, nearly one-in-ten Latino homeowners said they had missed a mortgage payment or were unable to make a full payment, while 3 percent said they have received a foreclosure notice in the past year. At the same time, 62 percent of Latino homeowners said there have been foreclosures in their neighborhoods and 36 percent say they are worried about their own homes going into foreclosure. The consequences of these policies have also brought the entire global financial system to the brink of collapse, destroying trillions in equity and untold numbers of lives. It is essential to reexamine the borrow-and-spend, high-leverage policies that became prevalent in the mortgage market as a result of well-intentioned-but-reckless decisions made by elected officials on behalf of the American people. Without such a return to fiscal discipline and responsibility, we will continue making the same mistakes that led us to the current financial crisis.
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