Not their fault

Regulators failed Fannie, Freddie

Now Congress needs to step up

July 15, 2008|By Peter Morici

Last week, share prices for Fannie Mae and Freddie Mac fell drastically on concerns they may lack adequate capital to cover mounting losses from defaulting loans.

Fannie and Freddie hold or guarantee about half the home mortgages in the United States, and if investor worries were to cause these enterprises not to be able to sell bonds to finance new mortgages, the U.S. economy could be cast into the worst crisis since the Great Depression. To avoid that, the government needs to take a more active role - fast - in stabilizing these essential institutions.

That process began Sunday evening, when the Federal Reserve announced it would lend to Fannie and Freddie as it does to banks, and the Treasury will seek congressional approval to increase its standby lines of credit and temporary authority to purchase equity, as needed, to ensure these firms have sufficient capital.

This not a bailout for badly run businesses; it is a reasonable response to a federal failure to adequately regulate banks, which has put these vital institutions at risk. The failure to curb abuses in the subprime sector - such as zero-down loans, zero-interest payment loans and loans with no documentation of income - helped create the housing bubble, which is now causing defaults on well-written Fannie and Freddie loans.

Foreclosure is expensive. When home buyers borrow from banks, they are required to provide down payments to cover losses if they fail to meet obligations. Normally, banks sell repossessed properties below market price and lose months of interest and legal costs. Consequently, banks require down payments of 20 percent or more of the appraised value when they keep mortgages in their investment portfolios.

For most working families, coming up with $20,000 or more to buy a first home is not practical. That's where Fannie and Freddie come in. Chartered by Congress as private stockholder companies, they make homeownership possible with small down payments.

They do this by purchasing low down payment loans from banks and either hold the loans or pool them into bonds for sale to investors, while guaranteeing the interest and principal will be paid. To assume this liability, Fannie and Freddie charge the banks fees that are passed along to home buyers, which vary in size according to the risk.

Generally, Fannie and Freddie buy only prime loans - loans to individuals with solid employment histories and good credit scores - and their default rates are well below those of banks on subprime and other, more-risky, mortgages.

The trouble is, Fannie and Freddie own or guarantee loans exceeding $5 trillion, but they only have shareholder capital of $81 billion - 1.6 percent of their liabilities. Large U.S. banks are required to have a minimum of 4 percent in such capital (6 percent is preferred).

Congress chartered these enterprises with minimal capital requirements because their lending practices are so conservative, and they were only seen to be at risk if home prices, nationally, went through a prolonged decline. Sadly, that has happened for the first time since Fannie Mae was chartered in 1938.

In recent years, private banks have pooled mortgages for sale to private investors that Fannie and Freddie would never touch. Thanks to lax federal regulation, they created bizarre mortgage products and loans that could never be repaid, but these allowed buyers to bid up home prices well above what could be sustained through conventional mortgages by qualified buyers.

Now the bubble has burst, home prices are down about 18 percent, and Fannie and Freddie face problems they did little to create. When home values fall, people are more inclined to walk away from mortgages. Although default rates on Fannie and Freddie loans remain much lower than those sold directly to investors by banks, these two enterprises saw losses of $11 billion in the nine months ended March 31.

Losses are expected to grow as the housing crisis works itself out, and Fannie and Freddie could face difficulty selling bonds to finance new mortgages. This would make mortgages difficult for many qualified Americans to obtain, housing prices would tank, and the economy would be thrown into panic.

The Treasury and the Fed are prepared to loan Fannie and Freddie cash. But these enterprises need to attract investors to raise more capital as a cushion against future losses. Until the storm swirling around the housing market subsides, this may not be possible.

Congress needs to move fast to permit the Treasury to purchase shares in Fannie and Freddie that may be sold to the public later. This may be the only way to avoid the failure of these vital institutions and the economic catastrophe that would ensue.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.

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