The Weight – The Final Chapter? by Jim Anderson

“Take a load off Fanny, take a load for free;

 Take a load off Fanny, and you put the load right on me.”

       The Band, Robbie Robertson, 1968

With a string of profitable quarters on the books, it seems that the fiscal weight of Fannie Mae and Freddie Mac peaked at $187.5 billion. These government-sponsored enterprises (GSEs) became wholly owned subsidiaries of the U.S. Treasury in 2008.  Fannie and Freddie are the only part of the financial sector bailout that hasn’t yet shown a profit for taxpayers, but that milestone will be reached later this year.

Now that the political spin-meisters have moved on and all the self-serving congressional hearings are over, the real history of the recent financial sector dislocation is slowly coming to the surface. At ground zero was the Community Reinvestment Act, which required banks to support their communities with mortgage loans to weak borrowers among other policies.

The sub-prime mortgage was born to satisfy the CRA requirement and grew to a total of 28 million households and $4.5 trillion at its peak. We remember Congressman Barney Frank publicly berating Fannie and Freddie’s regulator, declaring that he did not see any serious risk in their balance sheets and that he wanted to “roll the dice” on these sub-prime loans.

So Wall Street organized to feed the government beast and according to the American Enterprise Institute, by 2007, 85% of new mortgage originations purchased by Freddie and Fannie failed any reasonable standard for safety and soundness. Although many did not realize it at the time, the private mortgage lenders could never withstand that risk profile. Neither could investors in the securitization structures. They all went down together.

When the dust settled, the mortgage-backed securities market was comatose and banks were hesitant to lend without downstream liquidity. If you wanted a new mortgage or a refinancing, the GSEs, now in conservatorship, were the only games in town.

As anyone who has tried to get a mortgage in the last few years can attest, the U.S. market is an absolute mess. With Freddie Mac, Fannie Mae and the soon to be bailed-out FHA controlling 90 percent of the market, borrowers have about as much choice as someone trying to mail a first class letter. That lack of competition meant that homeowners had no choice but to attempt to run the months-long GSE refinancing gauntlet.

The unpredictable documentation requirements and the slow pace of activity at the government lenders meant millions missed out on the cash flow benefit the Fed was trying to deliver by keeping long-term rates low. In economic terms, it was a classic coordination failure.

The perfect storm of millions of defaulted mortgages and zero liquidity put an enormous strain on lenders, servicers, rating agencies and securitization specialists. Politicians, desperate to find a fall guy and deflect blame, attacked them all. Mess up the foreclosure paper work and you pay part of a $20 billion fine. Make a mistake in the securitization process and you will buy back those bad loans. Refuse to reduce principal for the borrowers, and Richmond, CA and North Las Vegas, NV will use “eminent domain” to make the reductions for you.

The U.S. mortgage contract used to be inviolate. It was a pillar of the housing market. Now it is fraught with risk. More importantly perhaps, all of this regulatory revenge has buried any efforts to work toward economically viable, innovative solutions for underwater borrowers. How can you convince anyone to enter this market as an investor in the face of all this government manipulation?

With profits finally reaching the bottom line, the Treasury announced in 2012 that they would reduce Fannie and Freddie’s portfolios 15 percent per year. At the same time, they increased the 10 percent dividend due the Treasury to a sweep of 100 percent of the profits. They have collected $132 billion so far. All this comes over the objections (and lawsuit) of private Preferred holders who have not received their dividends since the crisis began.

It is understandable that an Administration ever hungry for cash and denied further tax increases would take this extraordinary step. Still, there is a risk that Congress and the Administration will see only the cash cow and forget the essential role Fannie and Freddie played in the creation of the housing bubble. There may be an effort to keep them alive.

But don’t break out the champagne just yet. In a letter to the acting director of the FHFA, Fan and Fred’s regulator, Inspector General Steve Linick, points out that neither entity is properly taking reserves on loans over 180 days past due as required in the private sector. A good portion of the profits and cash payments to the Treasury might come from this single accounting misstep.

The recently introduced Corker–Warner Bill simply replaces the GSEs with a new, even larger government intervention via a new entity, the Federal Mortgage Insurance Corp. (FMIC).  Under this law, taxpayers would guarantee 90% of every mortgage or a total of $11.7 trillion of new direct taxpayer obligations.

This idea is puzzling.  Properly structured and priced, mortgages should be an attractive component of any fixed income portfolio. There is no obvious reason that these guarantees are necessary, other than to give the government continuous control of this market. Since moral hazard flows from the fountain of government largess, this system would likely produce a second CRA problem.

We are certain that our semi-numerate elected officials have not yet absorbed the real lesson of the financial crises. That lesson is simply this: When governments intervene in markets they create distortions – a sort of economic fantasy land. The bigger the intervention, the greater the distortion created. Ultimately when their economic fantasy land meets economic reality, markets break down and the taxpayers end up holding the bag.

How can we be so certain that they have missed this essential truth? Just consider the expression “sub-prime student.