They gave ordinary Americans a home. And then the roof fell in

Fannie Mae and Freddie Mac set out as 'white knight' lenders bringing mortgages to the less-well-off. But an ideal born in the depression, says Philip Blond, could cause another one
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The Independent Online

President Roosevelt must be turning in his grave. The mortgage guarantee institution that was created to help solve America's depression-era housing crisis seems to have had a central role in instigating a new economic crisis – and perhaps even a new depression.

On this side of the Atlantic, the travails of Fannie Mae and Freddie Mac are part of that slow-motion American car crash that began in sub-prime mortgage lending and has now extended to these government- sponsored behemoths. On the evidence of the first quarter of 2008, both Freddie and Fannie are massively extended and even, by certain standards, technically insolvent.

At the end of March 2008, they had total credit outstanding of $5,300bn (£2,700bn), of which $1,600bn was debt and $3,700bn represented current credit obligations. But due to their federally sponsored status, the capital requirements for securing such leverage are astonishingly minimal. Against that $5,300bn loan exposure, Freddie and Fannie have only $8bn in capital. Each company has less than 2 per cent capital against its mortgage exposure; good practice would demand three times as much.

This situation – coupled with losses in 2007 of $2.1bn for Fannie and $3.1bn for Freddie, and Freddie's surfeit of liabilities over assets of $5.2bn – promp-ted William Poole, former chairman of the St Louis Federal Reserve, to claim on 10 July that both entities were insolvent on fair-value accounting rules.

Little wonder that shares in both FMs halved last week and that US Federal Reserve chairman Ben Bernanke has been looking at finding up to $200bn for recapitalising them. Last week Hank Paulson, the US Treasury Secretary, announced moves to secure funding for the two organisations.

Many feel they are simply too big to fail. They hold or guarantee over 80 per cent of all US mortgages and as such they are uniquely exposed to the precipitous fall in the value of US housing stock, already down nearly 18 per cent from its July 2006 peak. Moreover, if the asset base of Fannie and Freddie continues its rapid rate of decline, and the US government cannot hold a middle line, then either both businesses will collapse or the debt will be nationalised and move on to the government's books. If either of these extremes occurs, it will make the sub-prime crisis and the current slowdown look like a golden period.

The contagion of over $5 trillion dollars in securitised mortgage debt has already spread across the planet. Indeed it was Freddie Mac, in 1971, that developed and introduced the first ever mortgage-related security. If the guarantors of this defaulting and devaluing asset base (US taxpayers) decide that the obligations to Freddie and Fannie are strictly speaking non-existent, then it really could be the depression all over again.

Fannie Mae began life in 1938 as the Federal National Mortgage Association, a body specifically established to provide housing finance for millions of depression-era Americans. Its crucial role was to offer refinancing of high-rate loans and the provision of funds to other banks to enable them to do the same. In 1968, as part of a desperate attempt to finance the Vietnam war, the Johnson administration privatised Fannie Mae and reconstituted it as a government- sponsored enterprise (GSE), which had the peculiar character of a profit-focused and shareholder-owned enterprise that existed for a public mission.

The ability of Fannie to gain access to US Treasury money at a lower rate than its rivals led to fears of a monopoly. So in order to create competition another GSE, Freddie Mac (the Federal Home Loan Mortgage Corporation), was created in 1970 with a similar structure and social mission. But given their quasi- federal status and consequent low loan rates, the shareholders of both outfits saw a unique opportunity to push for expansion in both market share and profits. The scale of this growth has been startling: the proportion of outstanding US home mortgage debt held or guaranteed by Fannie and Freddie rose from 6 per cent in 1971 to 51 per cent in 2003 and to 84 per cent this last quarter.

Ordinary retail banks and lenders have to get mortgages off their books to create the liquidity to sell more financing to homeowners. So they sell their mortgages to the GSEs, which guarantee them for a fee and sell them on to other investors as quasi-federal-backed loan securities that pay a guaranteed rate of return. In addition, both companies retain some of those mortgages ($1,600bn of them) for interest income and hedging.

In order to buy these mortgages, both Freddie and Fannie borrow money. This debt is itself often sold on to commercial banks to generate further liquidity to enable market expansion. As a result, many commercial banks fear an unprecedented writedown as they are often doubly compromised holding both mortgage-backed securities and agency debt.

For Paul Krugman, the re-nowned economist, the FMs are innocent parties in the sub-prime-engendered housing meltdown. Freddie and Fannie can't be behind the current asset implosion, he argues, as they are not allowed to offer sub-prime loans and require instead that any mortgages they issue are a verified 80 per cent of equity only. Given that in some cities values are down by over 25 per cent and still falling, he suggests the FMs are only in trouble because the housing market has declined to such an extent that the 20 per cent hedge is not enough to insure against erosion of asset values.

Well not quite. Underwriting standards at Freddie and Fannie were progressively relaxed from 1991 onwards. Initially a borrower had to put some money down, have a good credit score and a debt-to-income ratio of 36 per cent. However, under pressure to expand home ownership and increase profits, the FMs relaxed the credit scores and increased the ratios to 55 per cent.

That trend continued with the introduction of community lending programmes that in effect were 100 per cent mortgages with insurance covering the gap.

So not only did Freddie and Fannie massively expand the mortgage market – enabling people to borrow more and more and so pushing prices higher and higher – they also wrote less than prime loans.

The interests of shareholders in minimising their capital liability and maximising their loan leverage, and therefore their profit, were a paramount concern here. The investors helped to facilitate a favourable political climate for such largesse – substantial sums were donated to congressional figures and their entertainment.

Now, however, after William Poole's claim of insolvency, the emperor has no clothes. Both FMs require billions of dollars of public money just to stay solvent, and that is the best-case scenario. If asset values continue their vertiginous decline then all bets are off and a full-scale meltdown is possible.

The real tragedy, however, is the betrayal of Fannie Mae's original mission to house the poor. If only Freddie and Fannie had used their profits to extend mortgage insurance and thus fixed- rate mortgages to the sub-prime classes, who only wanted to share in the wealth, then this recession need never have happened. You don't extend home ownership by concentrating on financing the middle class.

Largely abandoned, the disadvantaged have slipped into the arms of loan sharks, who with zero "teaser" rates and vast increases in subsequent payments, have hoodwinked millions of aspiring Americans.

Sadly, the ultimate legacy of Fannie and Freddy is the new legions of the dispossessed and disinherited.