Fannie Mae Demise -- A Meltdown Long in Coming?

Edward J. Dodson

[An unpublished essay written September, 2008]

The past few years have been difficult in the extreme for the two U.S. Government Sponsored Enterprises (GSEs) - Fannie Mae and Freddie Mac. Now, because of the concerns of international investors over the safety and soundness of bonds and guarantees issued by the GSEs, the U.S. government has moved in to take over management of their activities. The market value of the outstanding shares of stock issued by the GSEs disappeared almost overnight, the loss in asset value leaving the GSEs with insufficient net worth to cover credit losses associated with defaulting mortgagors.

What seemed like an overnight meltdown actually had been coming on for over two decades. The GSEs have been operating under stresses both internally- and externally-created. Their top management teams consistently failed to recognize or understand the signs, gradually pulling their companies down a path exposing them to ever-greater risks of financial collapse. They became casualties of and willing participants in an inherently dysfunctional market.

I offer here a very personal perspective on what happened at Fannie Mae, based on a 20-year career with the GSE that began late in 1984 and ended with my retirement early in 2005.

Prior to joining Fannie Mae as a supervisor over a small team of review underwriters, I had been in charge of the mortgage lending program for a large, regional bank based in Philadelphia. Early in 1984 this bank merged with (or, more accurately, was acquired by) the Pittsburgh-based PNC Bancorp. The head of my division soon informed me that our bank's mortgage originations and servicing activities would be taken over by PNCs mortgage banking subsidiary. As the nation's financial institutions were in the midst of consolidations triggered by Reagan-era deregulation, I looked around for a new employer where my background and abilities could be put to good use making a living. Shortly thereafter, I joined Fannie Mae working out of the Northeast Regional Office in Philadelphia.

Fannie Mae had been an agency of the U.S. government until privatized during the Presidency of Lyndon B. Johnson, who needed to raise cash for the War on Poverty and continued military adventurism in Southeast Asia. What Fannie Mae offered to investors was a portfolio of fixed-rate mortgage loans the company purchased from commercial banks and mortgage bankers. Two years later, Freddie Mac was chartered to provide a secondary mortgage market for mortgage loans originated by the nation's savings banks and savings and loan associations (the Thrifts). The additional role of the GSEs was to create uniformity in loan documentation, eligibility requirements and creditworthiness in all markets across the United States.

The 1970s proved to be financially-challenging years for the GSEs. The rising costs of raising funds in the global credit markets inhibited expansion of their mortgage loan portfolios because of restrictions imposed on the rate of interest lenders could charge borrowers purchasing homes. The GSEs faced the age-old problem of having to borrow from sources willing to lend only for short periods while purchasing mortgage loans with a 30-year term (and an expected life of around 12 years). Circumstances worsened as depositors pulled their funds from the Thrifts and commercial banks to take advantage of higher yields offered by the new money market funds. This problem was only partially solved when the U.S. Congress finally lifted restrictions on mortgage loan interest rates and permitted the Thrifts and banks to issue their own certificates of deposit to compete with the money market funds.

The playing field did not suddenly become level. Commercial banks always had the advantage of diversification of risk - making consumer loans, issuing credit cards, and offering credit to businesses at rates of interest that reflected the potential for default and volatility of their cost of funds. The Thrifts, on the other hand, remained saddled with their low-yielding portfolios of residential mortgage loans. With deregulation, many Thrifts sought to improve their financial position by moving into business sectors dominated by the commercial banks. For many of the Thrifts, their inexperience in these other sectors resulted in high levels of default, insolvency and dissolution or acquisition. The GSEs were able to provide some relief to the commercial banks and Thrifts by purchasing their residential mortgage loan portfolios, although such purchases were made at a deep discount in order to compensate for the spread between the stated and current market yield requirements.

One of the factors that softened the financial impact and permitted these portfolio transactions to occur was the ability of the selling lender to record losses not at the time of sale but as each homeowner made the monthly mortgage payment. Amortizing losses over the life of the mortgage loan meant that a time might return when market interest rates would fall closer to the stated promissory note rate, or even return to par, so that no loss at all had to be recorded.

At the time I joined Fannie Mae, the company was losing around $1 million each day because of the negative spread between its cost of funds and the interest income generated by its loan portfolio. Thousands of thrifts and some commercial banks were in a similar position.

The Federal Reserve System made matters worse in 1979 by taking the advice of economist Milton Friedman and abandoning efforts to keep interest rates stable in favor of trying to control the money supply. The U.S. economy was already experiencing stagflation driven by OPEC-induced rising fuel costs and heavy tax burdens on producers. Interest rates skyrocketed, causing the housing sector to come to a screeching halt. Existing homeowners stayed put. Selling one's home and repaying a 5 percent mortgage loan made no sense when the rate on a new mortgage loan might be as high as 15 percent. For the GSEs and the Thrifts the desperate need was to develop new sources of income.

Two innovations appeared just as the economy was beginning to recover from the depth of recession.

First, the regulators approved the origination of mortgage loans with periodic adjustments in the rate of interest. The adjustable rate mortgages (ARMs) matched the duration of interest rate yields with interest rate risk by linking periodic adjustments to a stated index (e.g., one-year U.S. Treasury obligations). As conditions in the general economy improved and interest rates declined, ARMs enabled qualified homebuyers to close on new homes, with the prospect of eventually being able to refinance into an affordable fixed-rate mortgage loan down the road.

Second, the regulators approved a proposal by the GSEs to pool mortgage loans together as specific collateral for a new kind of liquid mortgage-backed security (MBS), essentially an amortizing bond to be sold by Wall Street to investors. The MBS appeared just as the Reagan administration pushed through measures further deregulating the financial services sector and significantly lowering the marginal tax rates on the nation's highest income recipients. Thus, in addition to land, real estate, the stock and bond markets, billions of dollars in new-found disposable income found their way into the new MBS market. The GSEs put their stamp of approval on the underlying collateral (i.e., the mortgage loans) originated by lenders who met minimum capital requirements, were deemed capable of servicing the loans they originated and were regularly monitored by the GSEs.

For reasons beyond the scope of this brief commentary, interest rates on long-term mortgage loans gradually came down during the early 1990s. Residential real estate once again became a seller's market in many parts of the United States. Inventories of newly-constructed homes found buyers, and the pace of new construction increased (although few builders broke ground without a sales contract and mortgage approval in place). Millions of homeowners who had purchasing their homes when interest rates were high refinanced their homes, either lowering monthly mortgage payments by hundreds of dollars or shortening the term of their loan from 30 down to as few as 15 years. As property values inched upward, many homeowners also refinanced credit card and installment debt, refurbished or expanded their homes, or simply took cash to pay for their children's college expenses or other personal expenditures.

By 1994, when I moved into a new position as a business manager and market analyst within the Housing & Community Development (HCD) group at Fannie Mae, the volume of business we were doing increased beyond anyone's most optimistic forecasts. We were all scrambling to strengthen our internal systems and controls, and all around the company task forces were established to lift what was a rather sleepy and bureaucratic company into a technology-driven financial giant. New faces constantly arrived. Departments and divisions underwent a series of reorganizations. New priorities were adopted, and a year later changed and resources redirected. As profitability returned and climbed, Fannie Mae's Chairman, James A. Johnson, took the company in an aggressive new direction. Our HCD group would expand all across the United States, covering every regional market in the U.S. with a local office charged with developing strong relationships with public and private stakeholders focused on meeting affordable housing and community revitalization needs. We analyzed and re-analyzed our eligibility criteria and creditworthiness guidelines in an effort to make homeownership attainable for minorities and younger adults. Members of Congress pressed us to do even more, and so new innovations were brought to the market each year.

What hardly anyone I worked with or came into contact with during my professional life appreciated was that market forces were constantly adding stress to a very vulnerable economic system. With every innovation we made to expand the pool of qualified homebuyers, land prices rose. With every fall in interest rates, land prices rose. These increases in land prices were reported as an increase in the median price of housing, and as a decline in the housing affordability index. Yet, every year, the GSEs announced an increase in the maximum loan amount we would purchase or securitize, compliantly adding fuel to the speculative nature of land markets. What received little attention or concern was the fact that what people were purchasing and financing each year was less a house and more a parcel of land. And, as property prices rose to levels threatening the volume - and profitability - projections demanded by Wall Street stock analysts, the GSEs had to come up with even more aggressive product designs that reduced or eliminated the amount of cash savings borrowers needed to purchase a home.

By 2005, an increasing portion of Fannie Mae's business was coming from market segments where default risk was considerably greater than even a few years earlier. Moreover, mergers and acquisitions within the financial services sector meant that only a small number of institutions accounted for the overwhelming majority of Fannie Mae's business. When one customer accounts for, say, 10 or 15 percent of your total business volume, the leverage shifts considerably in favor of what that customer asks for. In the MBS market, this translates into the size of the guarantee fee charged on a particular book of business. An objective analysis of the risk characteristics of loans being securitized might call for a guarantee fee of 50 basis points; however, to keep the customer's business might require accepting a much lower guarantee fee. The decision is a difficult one: expose the company to greater risk of loss, or lose market share to Freddie Mac, the Federal Home Loan Banks, or to a private placement MBS rated by a bond rating firm and marketed directly by Wall Street.

In the midst of all this frenzy, a huge segment of the mortgage market affecting the GSEs was totally beyond their control. FHA had fought to increase its own loan limits in an effort to attract a part of the conventional market and thereby offset its higher risk business with loans that traditionally perform much better. New marketing techniques attracted millions of homeowners to companies offering mortgage loans to people who had problems with their credit. Many of these companies engaged in predatory lending practices and outright fraud. As we now know, the bond rating companies essentially ignored the underlying risks associated with this business so that Wall Street could bundle the loans and market the securities to yield-hungry investors.

This house of cards began to collapse after 2005, and the meltdown of the system is now upon us. What happened to Fannie Mae and Freddie Mac need not have happened. We have it in our power to tame our land markets by the rather simple step of collecting land value (i.e., the annual rental value of every land parcel) to pay for public goods and services, and distribute any surplus to each citizen as an income supplement.

During my years at Fannie Mae, I did what I could to raise the level of awareness among my colleagues of the dysfunctional nature of our land markets. At one point, I even spent a few hours in discussion with Larry Small, at the time President of Fannie Mae. A few years before my retirement, I did achieve a minor breakthrough of sorts. The Vice President I reported to in the HCD group agreed with me that the taxation of land values was an important component to increasing the supply of affordable housing. I was able to develop a presentation on the issues and began delivering the talk at meetings organized by our offices in cities such as Pittsburgh and Buffalo. Unfortunately, this was also the time when Fannie Mae's Chairman, Franklin Raines and the CFO, Tim Howard, were forced to step down because of serious accounting irregularities. As we know, things have gone from bad to worse and are surely to get even worse before we touch bottom.