According to a new book by my friend and co-author, Viral Acharya, and his colleagues, at the Stern School of Business, New York University, Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, the role of government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, in precipitating the financial crisis of 2008 deserves special attention. According to the authors, while understanding the role of these GSEs is valuable in and itself to avoid a similar crisis in future in the US, understanding their role may also offer important lessons to other countries where the government plays a critical role in the financial sector. India is an important case in point.
The Federal National Mortgage Association, commonly known as Fannie Mae, and The Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac, are GSEs that were set up to further the American dream of affordable housing for every household. Specifically, their mandate was to increase lending for homes by securitising mortgages in the form of mortgage-backed securities, thereby allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market.
The authors illustrate the role of Fannie Mae and Freddie Mac in precipitating the financial crisis by drawing a parallel to the following investment opportunity in a hedge fund. Suppose that for every $1 that I invest, you will lend me $39. With our combined capital, I will buy bank-originated pools of home-mortgages that are not only difficult to sell but also face significant long-term risks. Although I will try to limit these risks by employing sophisticated financial hedging instruments, I must admit that my model for estimating these risks is prone to error and is ridden with uncertainty. I will invest 15% of the funds in low-quality mortgages that households will be unable to pay if a recession or a severe housing downturn occurred. I promise that given the significant emphasis on housing by the US politicians, I eventually run the largest US financial institution in terms of mortgages-related assets. I will buy around $1.7 trillion worth of such assets so that my institution would truly be too big to fail.
Wait, I am not finished! We will offer insurance on $3.5 trillion of home mortgages and guarantee them against default. We don?t want much for offering this insurance?maybe around $0.20 per $100.00 of mortgage. That will be enough to generate about $7 billion in profits per year. As my lender, are you worried about the capital I will hold as a buffer against future uncertainties? Well, for every $100 that we guarantee, I will hold only $0.45. And because we want as big a market share as possible, we are going to bolster some dicey mortgages as well. Since the risk of defaulting on my obligations to you is very high, I?m sure that you are expecting a big return. However, I am only going to pay you a little more than the yield on government bonds.
If you?re in your right mind as an investor, you would think my investment pitch is crazy and would reject the deal outright. However, if I whispered to you that I have a wealthy uncle?his name is Sam?that will make you whole on the money that you lent us no matter what happens, do you care about the risk? If you believe that Uncle Sam is not vanishing anywhere, you will certainly lend me your money.
As the authors rightly point out, the above investment strategy is not only a description of the business model of Fannie Mae and Freddie Mac leading up to the financial crisis but also of government-sponsored/ government-controlled financial firms in most countries. Needless to say, they are guaranteed to fail.
These failures were indeed anticipated. On September 30, 1999, a New York Times reporter, Steven Holmes, published a piece titled ?Fannie Mae Eases Credit to Aid Mortgage Lending?. He reported that Fannie Mae was lowering its credit standards, which, in turn, would increase home ownership. Franklin Raines, the CEO of Fannie Mae at the time, 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.? The story analysed 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. A decade later, Steven Holmes seems to resemble Nostradamus in predicting this failure. However, according to the authors of this book, one did not have to be Nostradamus to know that these government-sponsored enterprises were indeed guaranteed to fail.
Fannie and Freddie became a political football between the left and right wings 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. While politicians of both hues quibble about who should be blamed more: these GSEs or lax regulation and the consequent excesses by Wall Street? Although both have to be blamed together, according to the authors, these arguments are beside the point.
The authors argue that the poisonous mix of narrow political objectives, lobbying and misplaced incentives ensured that the ?state-financed? promise of fulfilling the American dream eventually gave the dreamers tears and considerable hardships and only hastened to push their dream into the improbable future. The primary failure of Fannie and Freddie lay in its ownership structure: heads I win, tails you lose; or, in other words, the privatisation of profits (for the shareholders and executives) in good times but the socialisation of downside risk (for the taxpayer). In short, Fannie Mae and Freddie Mac failed because they were run as the largest hedge fund on the planet.
The author is a PhD in finance from the University of Chicago and is currently faculty in finance at the Indian School of Business
https://www.financialexpress.com/columnists_landing_page.php?pg=1&username=krishnamurthyvsubramanian