Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, by Bethany McLean (Columbia Global Reports, 159 pp., $12.99)
This spring will mark ten years since American home prices peaked. The crash that followed precipitated an economic crisis that still hasn’t resolved itself. The Great Recession inflicted a national trauma that is inflaming a third presidential election. A decade on, we have lots of unfinished business. As Bethany McLean, who rose to fame more than a decade ago by helping break the story of Enron’s collapse, writes in her latest book, Shaky Ground, neither President George W. Bush nor President Barack Obama ever figured out what to do about Fannie Mae and Freddie Mac, the multi-trillion-dollar mortgage behemoths that make a mockery of our free-market economy.
Fannie and Freddie are a result—and a cause—of what McLean calls “America’s cult of home ownership.” The federal government created Fannie during the Depression to serve a noble goal. The government-chartered agency would offer 30-year, fixed-rate mortgages to American homebuyers. This stability, not available from private bank lenders, would insulate Americans from a speculative boom-and-bust financial industry that had driven up housing prices with too much mortgage credit before 1929, and, afterward, helped crash the housing market with too little. Thanks to Presidents Herbert Hoover and Franklin Roosevelt, writes McLean, “the mortgage market in the United States developed differently than it would have, and differently from other countries.” Even now, nowhere else in the world—except Denmark—can people purchase homes with no interest-rate risk. In America, if rates are low when you buy a house, your mortgage rate will stay low forever, even if rates rise later. If rates are high when you buy, you can refinance later, when rates fall.
In providing this product, Fannie and Freddie achieved something “Rumpelstiltskin would envy,” explains McLean. By guaranteeing the home loans that make up the mortgage-backed securities that investors buy, Fannie and Freddie “took the worst possible investment” from a bank’s point of view, “and turned it into the second most liquid instrument in the world,” behind U.S. Treasury bonds. “Around the world,” by contrast, “the most common mortgage product is a shorter-term adjustable-rate mortgage,” she notes. In most other countries, homeowners must pay more when rates rise, thus insulating banks from this risk.
We live in a democracy, of course, and if Americans want the federal government to be in charge of the most valuable private asset they own, that’s too bad for those who prefer a free market. Except, McLean points out, Americans and their politicians don’t want to admit that the federal government is in charge. Our denial about Washington’s dominance of housing dates back to 1968, at least. That year, a review of the federal government’s fiscal practices suggested putting mortgage debt officially on the government’s books. But the Johnson administration balked at this expansion—or seeming expansion—of government debt. Instead, the government made Fannie a company owned by private-sector shareholders. Washington started to buy Fannie’s debt, though, as a sign that the Treasury stood behind the now-private company’s obligations. Washington created Freddie Mac two years later as competition for Fannie, but the two firms do the same thing.
Before 2008, Fannie and Freddie were “like mythical beasts—part government agencies and part normal companies.” Washington didn’t officially guarantee Fannie and Freddie’s growing debt, because that would constitute government interference in the private marketplace. But, in a crisis, it was understood that Washington would protect the investors who purchased that debt. For a while, the companies followed the conservative American approach to credit. Remember, it was hard to get a credit card until the 1970s. Homebuyers had to put 20 percent down. But by the 1990s, 3 percent down payments were common. People could use Fannie- and Freddie-backed mortgages not only to buy houses but also to borrow more money against the houses they already owned—a far from prudent idea.
By the 2000s, government dominance of the mortgage market, combined with a lack of regulation in the small part of the market not controlled by Fannie and Freddie, had catastrophically combined. Because house prices seemingly never went down, and because mortgages were always available to everyone no matter what, housing seemed like the most prudent investment in the world. It followed that anybody could get a mortgage for a house or multiple mortgages for multiple houses. As the Florida strippers-turned-housing-investors in the film version of Michael Lewis’s The Big Short tell the audience, if you couldn’t afford your mortgage, you could always sell your multiple houses at higher prices or refinance at ever-lower interest rates to save money each month.
By 2006, there were no more buyers left, and interest rates were rising. When house prices stopped going up, the strippers had only one way out: default. Everyone knows the rest: the bursting of the credit bubble took the global economy down. Starting in March 2008, under a Republican administration, Washington had to put trillions of dollars in taxpayer money behind private financial institutions so that the world’s largest banks and insurers wouldn’t collapse.
Eight years later, the economy has recovered, sort of. The nation has gained back the 8.8 million private jobs it lost starting in 2008. Today, we have 5.3 million more jobs than we had back then. Sure, firms such as Citigroup and AIG should have gone into bankruptcy for the mistakes their executives made. But at least they have repaid their bailout money. And the Dodd-Frank financial reform law of 2010 allowed politicians to say—not correctly, but never mind—that they had ended “too big to fail” for large banks.
But Obama and Congress haven’t even pretended to fix Fannie and Freddie. In September 2008, McLean reminds us, investors from China to Japan were losing faith that Fannie and Freddie could make payments on all those mortgage bonds they had bought. That loss of faith on what was then $5.2 trillion worth of securities could cause an even deeper global downturn. So Washington took Fannie and Freddie into something it called “conservatorship.” The federal government took ownership of Fannie and Freddie and used Treasury money to send a message that it would make good on all those mortgage obligations even if more people stopped paying their home loans. Government control of Fannie and Freddie also allowed Washington to bring mortgage rates down to new record levels, keeping as many people as possible from defaulting on their homes—and bringing new people into the housing market, propping up prices.
Both the Bush administration and, later, the Obama administration were clear that government ownership and control weren’t a permanent solution. They’d come up with something, they said. So far, they haven’t. “No one who was involved would have guessed that [Fannie and Freddie] would still be in the state of limbo known as conservatorship,” writes McLean. It’s been so long now that almost no one cares: when’s the last time you heard Fannie and Freddie mentioned on the campaign trail?
We should care, though. For one thing, Fannie and Freddie control more of the mortgage market than they did before 2008. More important, Washington didn’t take over 100 percent of Fannie and Freddie’s stock, but slightly less than 80 percent. Higher ownership than that 79.9 percent percentage might have meant that the government would have to include Fannie and Freddie debt on Washington debt ledgers, something that Bush, like LBJ, wanted to avoid.
Not everyone understood that the government wasn’t serious in 2008 when it left some stock outstanding for private investors to buy. In the years since, hedge funds and small investment firms saw an opportunity: the housing market was healing, and Fannie and Freddie were about to pay back their government loans and start making profits again. So these investors bought the stock, thinking it would be worth something. To prevent them from cashing in, the government changed the terms of the bailout. Fannie and Freddie now would have to send their profits to the Treasury, with nothing left over for private shareholders. This approach was “radically less generous” than Washington was to the shareholders of banks such as Citigroup and Bank of America, writes McLean. Today, the Obama administration and Congress are using Fannie and Freddie profits as a deficit-reduction device: the firms provided $178 billion to the Treasury in 2013 and 2014.
So what? Speculators shouldn’t profit from these bailed-out companies at the expense of the U.S. taxpayer, right? Yet, there’s something distasteful about the government pretending to leave some Fannie and Freddie shares in the hands of private investors, then snatching away value from those private investors once it materializes. If Washington had wanted to nationalize the mortgage companies fully, it should have done so. There’s something dangerous as well about Treasury leaning on the mortgage giants to fund its own budget. How can we ever shrink Fannie and Freddie if we depend on them to pay other bills?
As McLean explains, everybody hates the mortgage giants, but nobody wants to take responsibility for what would happen under a different system. Nobody wants to find out, for example, what investors would think of Fannie and Freddie’s existing bonds if the firms ceased to dominate the mortgage market. Nobody wants to tell Americans that they don’t have an inalienable right to cheap mortgages. If fixing Fannie and Freddie were just a matter of taking cheap loans away from poor people, the task would be easy—or easier. Washington reformed welfare, after all. But cheap mortgages have become a middle-class entitlement. No two-income family wants to find out that the household’s hard-won investment is worth less than it was last year because new buyers can’t borrow as much to pay yesterday’s price. “No politician wants to be responsible for the loss of something Americans have come to see as a right,” McLean concludes.
So Fannie and Freddie teeter along, with far less capital—a financial cushion that companies need in case of a downturn—than banks and insurers have. They continue to distort the mortgage market by providing money far too cheaply to people who want to buy homes. McLean is a pragmatist, and she’s familiar enough with the financial world to grasp the unintended consequences of intervening in established markets. She suggests that we “fix what we have.” The government should force Fannie and Freddie to hold more capital than they currently do, instead of pilfering it to subsidize budget deficits. She writes, correctly, that it’s impossible to go much further without “mov[ing] away from the cult of homeownership.” Even if we’ve made a bigger mess than we can easily get out of, we need to know the facts. McLean ably presents them in this crisp, clear narrative.
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