GUARANTEED TO FAIL Fannie Mae, Freddie MAc and the Debacle of Mortgage Finance V i r a l a c h a r ya M at t h e w r i c h a r d s o n s t i j n V a n n ieuwerburgh l a w r e n c e j . w h i t e Guaranteed to Fail Fannie, Freddie, and the Debacle of Mortgage Finance Forthcoming January 2011, Princeton University Press Authors: Viral V. Acharya, Professor of Finance, NYU Stern School of Business, NBER and CEPR Matthew Richardson, Charles E. Simon Professor of Applied Financial Economics, NYU Stern School of Business and NBER Stijn Van Nieuwerburgh, Associate Professor Finance, NYU Stern School of Business, NBER and CEPR Lawrence J. White, Arthur E. Imperatore Professor of Economics, NYU Stern School of Business To our families and parents - Viral V Acharya, Stijn Van Nieuwerburgh, Matt Richardson, and Lawrence J. White 1 Acknowledgments Many insights presented in this book were developed during the development of two earlier books that the four of us contributed to at NYU-Stern: Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009); and Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, October 2010). We owe much to all of our colleagues who contributed to those books, especially those who contributed to the chapters on the government-sponsored enterprises (GSEs): Dwight Jaffee (who was visiting Stern during 2008-09), T. Sabri Oncu (also visiting Stern during 2008-10), and Bob Wright. We received valuable feedback on the first draft of the book from Heitor Almeida, Ralph Koijen, and Amit Seru, useful expositional comments from Sanjay Agarwal, Les Levi and Manjiree Jog, and excellent research assistance from Vikas Singh on how countries other than the United States deal with home ownership and mortgage markets. We would like to thank Robert Collender, principal policy analyst at the FHFA, for helping us better understand the FHFA data. We are also grateful to the professionalism of staff at the Princeton University Press, especially Seth Ditchik, who managed the process for us right from the book proposal to eventual publication. Finally, we owe substantial gratitude to a number of economists, policy-makers, and practitioners – some named in the book and others unnamed – who have over the past two decades studied the GSEs, with prescience pointed out the flaws in their design and warned of the likely adverse consequences due these flaws. Their collective wisdom has shaped our understanding of the GSEs in significant measure and helped us provide original recommendations for much-needed reform of mortgage finance in the United States. 2 Prologue Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance “The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.” - David Frum (columnist, and former speechwriter for President George W. Bush), National Post, July 11, 2008 On September 30, 1999, a New York Times reporter, Steven Holmes published a piece titled “Fannie Mae Eases Credit to Aid Mortgage Lending”. The crux of the story was that Fannie Mae was lowering its credit standards, which in turn would increase home ownership. Franklin Raines, the then Chief Executive Officer (CEO) of Fannie Mae, is quoted in the article: “Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements. Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' Consistent with sound journalism, the story analyzed the potential consequences of Fannie Mae’s foray into riskier lending. Quite presciently, the author Steven Holmes sounded an alarm that Fannie Mae was taking on large amounts of new risk, which in good times would not cause problems, but in a downturn could lead to a massive government bailout. The article also quotes Peter Wallison, an American Enterprise Institute scholar and frequent critic of the government-sponsored enterprises (GSEs), in particular, the two largest ones, Fannie Mae and Freddie Mac: “From the perspective of many people, including me, this is another thrift industry growing up around us…If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.” 3 A decade later, we know how it all turned out: the worst financial crisis since the 1930s and bailouts so large that we no longer consider the savings and loan debacle to have been much of a financial crisis. This is not to argue that all of the blame should be placed on the doorstep of Fannie and Freddie. There is plenty of blame to go around at other large, complex financial institutions including Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Wachovia, and Citigroup, among others. But, nevertheless, Fannie and Freddie do deserve special attention. Currently, as of August 2010, the Treasury has injected a total of $148.2 billion into these entities. And it doesn’t look like their financial health is going to get any better. Even putting aside all future foreclosures and portfolio losses, Fannie Mae and Freddie Mac are now sitting on over 150,000 foreclosed homes. The Congressional Budget Office (CBO) projects that an additional $65 billion may be required to keep them afloat until 2019. The CBO has further estimated that the total taxpayer losses might ultimately reach the neighborhood of an astounding $350 billion. Yet Fannie and Freddie barely register as news. In the most sweeping financial legislation since the 1930s, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 barely mentions them, simply calling for a study of how to reform them. Now there is a chance that the support that has been thrown at the banks – $550 billion of direct capital, $285 billion of loan guarantees, and insurance of $418 billion of assets – will be eventually paid off. In fact, a number of banks have repaid their loans with interest, albeit along a trail of real economy devastation. And even the poster child for financial excess, AIG, may be able to fully pay off the government if the housing market doesn’t deteriorate further. But the chances are slim to none that either Fannie or Freddie will be able to pay back the funds. When the history of the crisis is all written, these institutions will turn out to be the most costly of the financial sector, and this sector includes some of the most tarnished financial institutions in America. So where is the outrage? There is no outrage because Fannie and Freddie have become a political football between the left and right wing of American politics. On the left, they were vehicles for promoting affordable housing for all, while on the right they furthered the idea of the ownership society. And they were a politician’s dream: They reduced monthly mortgage costs without requiring any federal budgetary outlays. 4 Now that they have failed, and we have learned that the meal has been costly indeed, conservative think tanks blame Fannie and Freddie for being ground zero of the subprime crisis. However, the liberal groups say that their role in the crisis is overblown and that it is simply a diversionary tactic away from what they consider to be the true causes of the housing bust: deregulation and the excesses of Wall Street. There is probably a little truth to both views. But these arguments are beside the point. Fannie Mae and Freddie Mac are where they are because they were run as the largest hedge fund on the planet. A little calculation illustrates their business model. Suppose that we offered you the following opportunity: We will invest $1, you lend us $39. With this $40, we will buy bank-originated pools of mortgages that are not easy to sell and face significant long-term risks. Although we’ll attempt to limit that risk by using sophisticated financial hedging instruments, our models have large error and uncertainty. We’ll invest 15% of the funds in low-quality mortgages that households will be unable to pay in a recession or a severe housing downturn. And to make it even more interesting, we’ll become the largest financial institution in terms of assets that are related to mortgages and together buy around $1.7 trillion worth, making us truly too-big-to-fail. But it doesn’t stop here. We’re going to offer insurance on a whole lot more mortgages taken out in America, say $3.5 trillion (together), and guarantee them against default. We don’t want much for offering this insurance -- maybe around 20 cents per $100 of mortgage -- but that will provide us with $7 billion in profits per year (assuming absolutely zero foreclosures). As a lender to us, you might be worried how much capital we’ll hold as a buffer against all future defaults: for every $100 that we guarantee, we’ll hold only 45 cents. And because we want as big a market share as possible, we’re going to backstop some dicey mortgages. For this type of risky investment, we know that you are expecting a big return. However, we are only going to pay you the yield on government bonds plus a little extra.