How Fannie, Freddie and politicians caused the crisis

Article Highlights

  • Thanks to SEC investigation, GSEs have, for the first time, acknowledged the magnitude of their efforts to mislead investors

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  • GSEs’ credit guarantee portfolios contained $1.6 trillion in subprime Alt-A loans, meaning $1 trillion were misclassified

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  • Government's handling of GSEs was classic case of moral hazard that had infected the $11 trillion residential debt market

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By mid-2008 Fannie and Freddie (the "GSEs") had a combined $5.4 trillion in securities outstanding, all of which were backed by the GSEs' full faith and credit. These securities financed 45% of all the residential mortgage debt in the U.S. GSE securities were viewed as having the implicit guaranty of the U.S government and were aggressively marketed to investors worldwide.

Investors in GSE securities were led to believe that the vast majority of the loans backing these securities were low risk. Thanks to the SEC's investigation, the GSEs have, for the first time, acknowledged the magnitude of their efforts to mislead investors with regard the true nature of their exposure to subprime and Alt-A loans. Instead of $600 billion in subprime and Alt-A loans, the GSEs' credit guaranty portfolios contained $1.6 trillion. Thus approximately $1 trillion in subprime and Alt-A loans were misclassified. Given the GSEs' high leverage--each dollar of capital supported about $80 in debt--their insolvency was inevitable.

"Government housing policies and the toxic mortgages they spawned were the sine qua non of the financial crisis."--Edward Pinto

A default would have created panic. With the collateral backing the GSEs' securities being of unknown value and their corporate guarantees worthless, uncertainty as to the magnitude of losses would have contaminated the entire $5.4 trillion in outstanding GSE securities. Market values would likely have plummeted by 20% or more - creating losses of $1 trillion or more. Policy makers had encouraged investment in GSE securities by way of low capital requirements. As a result further insolvencies would have occurred as many investors in GSE securities were themselves highly leveraged. The impact on the FDIC alone would have been catastrophic since depository institutions held about $1 trillion in GSE securities.

The game was up. The federal government would now be forced to acknowledge full responsibility for the GSEs' liabilities. While the government had in effect established the GSEs as off-balance sheet Structured Investment Vehicles (SIVs) - investors had long assumed that he taxpayers were ultimately responsible. This was a classic case of moral hazard and it had infected the $11 trillion residential debt market.

The GSEs' contributions to the financial crisis were pervasive.

In 1991 community groups told Congress that Fannie and Freddie's conservative underwriting standards (such as a down payment) were standing in the way of liberalized underwriting by lenders. Fannie's CEO Jim Johnson saw this as an opportunity to solidify political support for Fannie and fight perennial efforts to limit or eliminate its charter benefits. It joined with the community groups in successfully supporting legislation in 1992 that imposed affordable housing goals on the GSEs.

In 1994 Johnson vowed to "transform the housing finance system" and "provide $1 trillion in targeted [affordable housing] financing." This was followed in 1995 by the Clinton administration's National Homeownership Strategy with a goal of greatly expanded home ownership. President Bill Clinton, when announcing the strategy said it would "not cost the taxpayers one extra cent." At the same time, the Community Reinvestment Act (CRA) was expanded and HUD announced its "Best Practices Initiative" with Countrywide as its leading acolyte. The central tenets of all these policies were the elimination of down payments, the use of "flexible and innovative underwriting" and "administer(ing) a review process for loan applications to ensure that all applicants have every opportunity to qualify for a mortgage" - all undertaken in an effort to greatly expand home ownership.

Over the next 12 years trillions of dollars in additional affordable housing and CRA commitments would be announced and fulfilled by Fannie, Freddie, Countrywide, and many of the nation's largest banks.

In a private interview with the chairman of the Financial Crisis Inquiry Commission, Treasury Secretary Timothy Geithner noted:

"Moral hazard was everywhere and endemic. The biggest source was in the GSEs [Fannie and Freddie]. The GSEs were entirely moral hazard."

Government housing policies and the toxic mortgages they spawned were the sine qua non of the financial crisis.

Edward Pinto is a resident fellow at AEI

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About the Author

 

Edward J.
Pinto
  • American Enterprise Institute (AEI) resident fellow Edward J. Pinto is the codirector of AEI’s International Center on Housing Risk. He is currently researching policy options for rebuilding the US housing finance sector and specializes in the effect of government housing policies on mortgages, foreclosures, and on the availability of affordable housing for working-class families. Pinto writes AEI’s monthly Housing Risk Watch, which has replaced AEI’s FHA Watch. Along with AEI resident scholar Stephen Oliner, Pinto is the creator and developer of the AEI Pinto-Oliner Mortgage Risk, Collateral Risk, and Capital Adequacy Indexes.


    An executive vice president and chief credit officer for Fannie Mae until the late 1980s, Pinto has done groundbreaking research on the role of federal housing policy in the 2008 mortgage and financial crisis. Pinto’s work on the Government Mortgage Complex includes seminal research papers submitted to the Financial Crisis Inquiry Commission: “Government Housing Policies in the Lead-up to the Financial Crisis” and “Triggers of the Financial Crisis.” In December 2012, he completed a study of 2.4 million Federal Housing Administration (FHA)–insured loans and found that FHA policies have resulted in a high proportion of working-class families losing their homes.

    Pinto has a J.D. from Indiana University Maurer School of Law and a B.A. from the University of Illinois at Urbana-Champaign.

  • Phone: 240-423-2848
    Email: edward.pinto@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: 202-419-5212
    Email: emily.rapp@aei.org

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