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Department of Housing and Urban Development
Initially, Fannie Mae and Freddie Mac were largely on the sidelines while private markets
generated increasingly risky mortgages. Between 2001 and 2005, private-label securitizations of
Alt-A and subprime mortgages grew fivefold, yet Fannie Mae and Freddie Mac continued to
primarily guarantee fully documented, high-quality mortgages.
But as their combined market share declined – from nearly 70 percent of new originations in
2003 to 40 percent in 2006 – Fannie Mae and Freddie Mac pursued riskier business to raise their
market share and increase profits. Not only did they expand their guarantees to new and riskier
products, but they also increased their holdings of some of these riskier mortgages on their own
balance sheets.
Fannie Mae and Freddie Mac strayed farthest from their core business in 2006 and 2007 – the
very moment the housing market was extending credit to the riskiest borrowers and home prices
were peaking. When home prices began to fall and adjustable-rate mortgages with low teaser
rates reset to higher rates, the Alt-A mortgages that Fannie Mae and Freddie Mac had
accumulated started to default at alarming rates.
By 2008, mortgages across the product spectrum, including high-credit, well-documented prime
mortgages, were defaulting at historically high rates. Fannie Mae and Freddie Mac’s losses had
become far too substantial for their thin capital buffers to absorb, and it became clear they would
be unable to fully honor their debts and guarantees. In September of 2008, in consultation with
the Bush Administration, FHFA placed Fannie Mae and Freddie Mac in conservatorship under
the authority provided by the Housing and Economic Recovery Act of 2008 (“HERA”) (Pub. L.
110-289), which Congress had passed to support the housing market two months earlier. The
Treasury Department agreed to exercise its authority under HERA to provide financial support –
to date, over $130 billion – so both Fannie Mae and Freddie Mac could honor their debt and
guarantees. These measures, though unfortunate, were necessary to prevent a more severe
disruption in the mortgage market and broader economy.
Fannie Mae and Freddie Mac’s structural design flaws, combined with failures in management,
were the primary cause of their collapse. Although some have suggested affordability goals
played a major role, the mistakes that led to the failure of Fannie Mae and Freddie Mac – poor
underwriting standards, under pricing risk, and insufficient capital with inadequate regulatory or
investor oversight – closely mirrored mistakes in the private-label securities (PLS) market where
affordability goals were not a factor. In fact, delinquency rates on many PLS securities and other
loans held by banks and other private market institutions were far higher than on the loans held
by Fannie Mae and Freddie Mac, including loans qualifying for the affordability goals. While
Fannie Mae and Freddie Mac’s affordability goals were poorly designed and did not effectively
serve their purposes (as detailed below), fundamental structural flaws and poor decision-making
are the principal reasons these institutions failed.
Fannie Mae and Freddie Mac’s profit-maximizing structure undermined their public mission.
Fannie Mae and Freddie Mac’s congressional charters require them to promote market
stability and access to mortgage credit. But their private shareholder structure, coupled with
a weak oversight regime, encouraged management to take on excessive risk in order to retain
market share and maximize profits, jeopardizing their ability to support the mortgage market
and leaving taxpayers to bear major losses. Their pursuit of profit leading up to the financial
crisis caused them to fail when their broader public mandate to support the market was
needed most.
Fannie Mae and Freddie Mac’s perceived government backing conferred unfair advantages.
Fannie Mae and Freddie Mac benefited from preferential tax treatment, far lower capital
requirements, and a widely perceived government guarantee – the commonly held
assumption that large losses would be backstopped by the taxpayer. These advantages gave
them substantial pricing power that helped them dominate segments of the market in which
they participated, build up large investment portfolios at a cost far lower than their
competitors, and take on irresponsible risks through their guarantee business that ultimately
resulted in their failure.
Fannie Mae and Freddie Mac’s capital standards were unfair and inadequate. Fannie Mae
and Freddie Mac were required to hold far less capital than other regulated private
institutions. Since they did not have to maintain higher levels of capital, they could set the
fee that they charged to guarantee mortgage-backed securities at artificially low levels. It
also left them with an inadequate cushion to absorb losses once the housing crisis hit.
Fannie Mae and Freddie Mac’s regulator was structurally weak and ineffective. The Office
of Federal Housing Enterprise Oversight (“OFHEO”), Fannie Mae and Freddie Mac’s
previous regulator, did not have adequate enforcement mechanisms or authority to set capital
standards to constrain risky behavior. Over the years, Fannie Mae and Freddie Mac’s
aggressive lobbying efforts had successfully defeated efforts to bring them under closer
supervision.
The financial crisis also exacerbated fundamental flaws in the FHLBs, which help mostly insured
depository institutions access liquidity and capital to compete in an increasingly competitive
marketplace. Prior to the crisis, the FHLBs suffered from inadequate regulatory oversight, and
were allowed to build large investment portfolios that subjected them to excess risk, while
providing concentrated funding to banks engaging in unsound business practices. Today, eight of
the twelve banks are under regulatory orders with respect to their capital or have voluntarily
suspended dividends or the repurchase of excess stock.
Because each of the twelve FHLBs is also liable for the losses of other FHLBs, additional losses
could adversely affect the entire FHLB system, damaging the mortgage finance market and
potentially constraining access to capital for financial institutions. Reforms to the FHLB system
are necessary to restore its important primary role of providing a stable source of mortgage credit
for financial institutions of all sizes.
Source: Department of Housing and Urban Development and Department of Treasury, February 2011
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