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Beholden or market-reactor? An alternative view for Fannie Mae and Freddie Mac's role in the 2004 to 2008 housing bubble.

INTRODUCTION

Much has been written on the collapse of the 2004 to 2008 housing bubble and a considerable proportion of this work suggests impropriety on the part of two Government Sponsored Entities (GSEs), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Perhaps the best example of this criticism is the American Enterprise Institute for Public Policy Research's September 2008 publication, "The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac" (Wallison & Calomiris, 2010) which does an exhaustive job of detailing actions and activities of the GSEs, leaving the reader to conclude that the sole motivation for Fannie Mae and Freddie Mac's actions was gaining and maintaining influence with members of congress--to whom the GSEs were clearly beholden--by promoting low quality loans, what might be termed the "beholden" hypothesis. The paper also suggests that the GSEs should shoulder the vast majority of blame for their own misfortunes and the cause and cost of the collapse in housing prices that started in late 2007.

Treasury Secretary Henry M. Paulson's (2010) memoir echoes Wallison and Calomiris, asserting the GSEs suffered from a failed business model and needed to be contained, if not eliminated altogether. Although neither Paulson nor Wallison and Calomiris offer a complete analysis of why 70 years of service providing liquidity to the secondary mortgage markets was a failure, they do hint strongly that government "characteristics" (i.e., regulatory practices) pressured Fannie Mae and Freddie Mac to focus on geographic areas and riskier projects that benefited specific members of the U.S. Congress.

Absent from these works is any suggestion Fannie Mae and Freddie Mac were simply responding to changing market conditions or that their actions were necessary to maintain market share and provide expected rates of return for shareholders--the objective of most privately held corporations, what might be termed a "market reactor" hypothesis.

Even as late as the second quarter of 2008, higher risk subprime loans were still a small proportion of the GSEs' portfolios (Fannie Mae, 2008 and Freddie Mac, 2008), however by that time, both Fannie and Freddie had expanded their activities into riskier loans and had accumulated derivative positions designed to hedge their portfolios. These included investments in Alternative A-paper (Alt-A) mortgages and other types of non-conforming loans (loans ineligible for the GSE's "prime" designation), especially in 2005 to 2007. While there is no reason to reject assertions that the GSEs pursued less creditworthy loans in an attempt to curry favor with various members of Congress, it is important to note that in 2005 -2007 originations of traditional mortgage business declined while subprime and other mortgage products increased along with competition from traditional investment banks and other private label consolidators for mortgages to be packaged into mortgage backed securities (Federal Housing Finance Agency, 2010).

This paper argues that GSEs pursued a "market reactor" strategy that attempted to adapt to changes in the market. We support this argument by first describing relevant characteristics of mortgage markets during the 2004 to 2008 period including a description of GSE holdings that characterizes the relative significance of Alt-A and subprime loans in the overall portfolio. We next show that GSE holdings in Alt-A and subprime holdings increased during the 2005 to 2007 period, further supporting the "market reactor" hypothesis. Finally, we examine characteristics of a declining origination market that influenced the GSEs' market adaptations. This serves as an alternative explanation for the GSEs' aggressive participation in the non-conforming mortgage market. The final section is used to summarize the results and review the continuing need for the GSEs.

MORTGAGE MARKET OVERVIEW 2004 TO 2008

Wallison and Calomiris' (2010) critique (what we call the "beholden" hypothesis), holds that Fannie Mae and Freddie Mac's failings were the result of their programs designed to help low income areas in return for favored status with elected officials (Wallison & Calomiris, 2010). In essence, the argument is: specific members of congress pressured these private companies to adhere to their mission and provide support for affordable housing through extra-legislative action. The more likely failing was because of their private corporation status which required the GSEs to make up for lost market share in the conforming mortgage market through the purchase of Alt-A and other non-conforming products. These mortgages, as a group, represented more expensive, less affordable housing that increased the GSEs' risk portfolio.

Some measure of confusion is understandable given the myriad of details associated with legislation and financial activities associated with the GSEs. A specific concern is the question of what defines the loan type, there is little consensus on the definition of a subprime loan. Rather, this distinction is made by the marketing unit that originates a loan. This can lead to a situation where very good loans might carry a "subprime" designation while poorer loans could have been written by a unit designed to create "prime" loans. Another source of confusion has to do with whether or not the GSEs were authorized to purchase any but investment grade (prime or AAA securities). If they were not, as the Economics Nobel Laureate Paul Krugman asserts (Krugman, 2008), the question arises as to why the GSEs had such loans. The "Expanded Guidance for Subprime Lending Programs" (Office of the Comptroller of the Currency, 2001) explains that conventional loans can develop credit problems, resulting in a lowered rating for loans already in the GSE's portfolios.

The other source of subprime exposure in the GSEs' holdings was private label securities composed of subprime loans that were inappropriately packaged as investment grade. In retrospect, classifying a package of subprime loans as AAA turned out to be ill advised, however this was an industry practice condoned by the rating agencies. Fortunately, this represented a very small (less than 2%) of Fannie Mae and Freddie Mac's portfolios.

The Extended Guidance document also suggests that a Fair Isaac Corporation (FICO) score of 660 or lower is indicative of a subprime loan, but other factors, such as loan to collateral ratios, should be taken into account when assigning designations. The GSEs' practice (prior to going into receivership) of reporting only FICO scores less than 620 as subprime was misleading, making it more difficult to evaluate the GSEs' risk exposure leading up to the housing collapse.

Given the significance of the 660 FICO score, there is merit in estimating the proportion of loan categories with lower FICO scores along with their Unpaid Principle Balance (UPB) based on Q2 2008 Investor Summaries (Fannie Mae, 2008 and Freddie Mac, 2008). Fannie Mae's mean FICO scores and proportions of loans with scores below 620 (4.8% and 0.3% for Alt-A and subprime loans respectively) can be used to make estimates of the proportions below 660. This approach puts the overall fraction of Fannie Mae's book with FICO scores below 660 at less than 16%. When applying the same method to the Alt-A portfolio the proportion below 660 would be 7.2%. By contrast, almost 78% of the subprime loans would have estimated FICO scores of 660 or less. Compiled information describing three categories of loans held by Fannie Mae can be found in Figure 1.

Fannie Mae's overall portfolio is slightly better than the Alt-A holdings on two metrics (Weighted Average FICO scores and Percent Weighted Average Original Loan to Value (OLTV) ratios); while the other three measures show the Alt-A loans have risk characteristics that make them considerably better than Fannie's overall portfolio. This observation along with the relative size of the Alt-A loans undermines the assertion that the GSEs purchased Alt-A loans to support affordable housing. Rather, the accumulation of Alt-A loans appears to be a more fundamental effort to maintain market share and increase profitability. Regrettably, given the ultimately higher foreclosure rates observed for Alt-A loans, it is safe to say there are important aspects of the credit worthiness of those loans that are not captured in these metrics. Figure 1 also demonstrates how the subprime mortgages are universally and considerably inferior to the overall portfolio. Whether loans such as Alt-A are creditworthy in more reliable markets, or are just simply bad, is a question yet to be decided.

Figure 2 provides support for the suggestion that Fannie Mae was aggressively increasing its holdings of non-conforming loans during 2005 to 2007. However, despite the spectacular percentage change in subprime holdings (up 286.2%) this component of Fannie's overall portfolio remained small, less than 1%. On the other hand, increasing purchases of other non conforming categories of loans (Interest-only, Loan-to-Value > 90, and Alt-A) did lead to their becoming a substantial proportion of the GSEs' overall portfolio.

As a final note on the new mortgage types that gained prominence in the 2005-2007 period, no doubt there are many who sold homes using Alt-A financing who would be offended by the derisive light cast on these types of products. As William Lopez (2005), Director of Mortgage Banking for Wholesale Lending Online, points out, these loans had not been shown to carry a higher foreclosure rate, at that time, hence it may be that the higher risks (which would require higher returns ceteris paribus) were not apparent to the GSEs prior to the mortgage crisis. Furthermore, as the risks became visible, Fannie Mae's management moved rapidly to withdraw from the Alt-A business. Whether Alt-A and the other mortgage innovations are generally imprudent or simply got caught in the backlash of the subprime juggernaut is a different question, but these types of loans now seem reckless. However in the euphoria of the 2005-2007 bubble these loans were regarded as new and innovative, and the extent to which they would contribute to excessive building of houses and the most significant economic collapse in modern times was yet to be seen.

AN ALTERNATIVE MOTIVATION

It may be true that Fannie and Freddie purchased subprime private label securities to help build the case they were fulfilling their mission to provide affordable housing. However we have pointed out the average UPB for Alt-A and interest only loans, two areas with exceptional 2005-2007 growth (shown in Figure 2), was well above the average for the entire book of residential business. Specifically, the average UPB, as an indication of home prices, was $146,503 for Fannie's overall book while Alt-A and interest only mortgages were $171,269 and $240,395 respectively-indicating Fannie Mae was more interested in higher end (less affordable) housing. However the UPB for subprime, OLTV > 90%, and loans where the FICO score was less than 620 do look like efforts to accommodate a mandate for affordable housing, with low average home costs compared to the overall book (Fannie Mae, 2008).

A more plausible explanation for the GSEs' expanded acquisition of non-conforming loans can be seen from information drawn from the Conservator's Report on the Enterprises' Financial Performance (Federal Housing Finance Agency, 2010) showing how three types of market forces were acting to erode the GSE's profitability. The first effect, illustrated in Figure 3, was a decline in the volume of mortgage originations from 2003 levels (a drop of more than 20% by 2005).

The second force, shown in Figure 4, depicts how increased competition from private label issuers caused the GSE's market share to decline by nearly 40% by 2005.

The third market reality was the changing composition of mortgage originations, Figure 5. Originations of conforming (prime) mortgages, the focal point of the GSE's mission, declined from more than 60% of all originations in 2003 to less than a third in 2006, while Alt-A and subprime originations grew from less than 10% of all originations in 2003 to a peak of 33% in 2006.

It is clear the combination of these three market forces and the prohibition against the GSEs purchasing subprime mortgages outright would have put considerable pressure on the management of Fannie and Freddie to find alternative means of improving stock performance.

Any responsible executive or board member would be very conscious of the share price and as the earlier description indicates the GSEs, as buyers of mortgages, were under considerable pressure. Figure 6 shows that even with substantial purchases of alternative mortgage products, Freddie's stock price through much of the 2005-2007 period demonstrated unremarkable performance when compared to major indices. On the other hand, despite the investments in non-conforming loans, Fannie Mae's stock performance through the 2005-2007 period was lower.

From 2001 into 2002 Fannie Mae's stock price held at approximately $80 per share, while 2002 through 2004 saw the price drop to approximately $70 per share, and in the 2005 to 2006 time period the share price was consistently below $60 per share--a fall of 25% in approximately 5 years. At the same time, major stock indexes showed consistent gains. Fannie Mae's stock price did manage to rally to around $70 per share in the time period when they accumulated the bulk of their Alt-A and other higher risk exposure; but, of course, this did not last.

This paper has provided evidence that contradicts the "beholden" hypothesis in favor of the "market reactor" explanation. In essence, much of the conventional rhetoric is an attempt to pin the blame for the 2008 economic collapse on the "quasi" nature of the GSEs, making far more of their "special" relationship with congress than is justified. More relevant, Fannie Mae and Freddie Mac were both public corporations with boards and management teams who had fiduciary responsibilities to provide higher returns to shareholders.

CONCLUSIONS AND FUTURE DIRECTIONS

During the 2005-2007 period, the management teams at Fannie Mae and Freddie Mac were confronted with changing market conditions that required they accept lackluster or declining stock performance or increase their involvement in nonconforming home loans. However, their participation in the riskiest loan types, subprime, represented a small proportion of their portfolio and was not large enough to have altered the trajectory of the real estate and banking industries. Although the final cost to the taxpayers for the GSE's miscalculations will not be trivial, it is far smaller than what is being endured in the more deregulated segments of the mortgage industry. Saddest of all is the human cost of the most severe economic downturn since the Great Depression, taking the form of lost equity in homes, lost jobs, as well as ruined futures.

The evaporation of non GSE participants in the face of the recent adversity casts aspersions on the underlying dynamic that brought about the explosion in emerging mortgage markets seen in the 2005-2007 period. Apparently the private originators are only able to operate in markets where a substantial portion of loans have interest rates including a subprime premium. However, even now in these unprecedentedly tough times for the post Great Depression era, mortgages are originated.

The last Figure (7) shows how the GSEs, along with the Government National Mortgage Association (Ginnie Mae), had (even with the acquisition of subprime and Alt-A mortgages) their proportion of all originations fall during 2004 to 2006. In addition, Figure 7 indicates that the GSEs continue to play a pivotal role in facilitating the American Dream of home ownership and increased economic activity. Although originations since the start of the recession are down dramatically, the proportion bought by the Enterprises and Ginnie Mae was nearly universal in 2008 and 2009. It is frightening to contemplate where the US economy would have gone without this all but sole source of liquidity and financing for the already beleaguered construction industry.

POLICY IMPLICATIONS

While Wallison and Calomiris (2011) suggest that changing regulatory and political forces were responsible for the increased exposure of Fannie Mae and Freddie Mac (the beholden hypothesis), we have provided support for a perspective that the GSEs were taking steps to earn back market share that was lost due to the competitive challenges they were facing (the market reactor hypothesis). The policy implications of this error in perspective are important. Focus on the culpability of GSEs in their reaction to congressional influence that results from accepting the beholden hypothesis fails to provide adequate emphasis on structural issues such as regulation of the GSEs and their quasi-governmental structure. Simply put, if congressional influence was the sole reason for the magnified impact of the mortgage crisis on the GSEs, then there is little reason to suggest any structural or regulatory changes in their administration. If, as is the thesis of this paper, their adaptation to changing competitive forces encouraged them to adopt more risky loan portfolios in order to gain market share, then the role of regulation in constraining those competitive forces should still be on the table.

Michael D'ltri, Dalton State College

Jon Littlefield, Dalton State College

REFERENCES

Fannie Mae. (2008, August 8). 2008 Q2 10Q investor summary. Retrieved February 3, 2011 from http://www.fanuiemae.com/media/pdf/newsreleases/2008_Q2_10Q_Investor_Summary.pdf.

Federal Housing Finance Agency. (2010, August 26). Conservator's report on the enterprises' financial performance. Retrieved March 26, 2011 from http://www.fhfa.gov/webfiles/16591/ConservatorsRpt82610.pdf.

Freddie Mac. (2008, August 8). Freddie Mac update. Retrieved February 3, 2011 from http://www.freddiemac.com/investors/er/pdf/slides_080608.pdf.

Krugman, P. (July 14, 2008). Fannie, Freddie and you. New York Times.

Lopez, W. (2005, June). Alt-A 101, Scotsman Guide Residential Edition, Retrieved February 3, 2011 from http://www.scotsmanguide.com/default.asp?ID=172.

Office of the Comptroller of the Currency. (2001). Expanded guidance for subprime lending programs, Federal Reserve Board, Federal Deposit Insurance Corporation, Office of Thrift Supervision, Retrieved February 8, 2011 from http://www.federalreserve.gov/boarddocs/srletters/2001/sr0104a1.pdf.

Paulson, H. (2010). On the brink: Inside the race to stop the collapse of the global financial system. New York: Business Plus/Grand Central Publishing.

Wallison, P., & Calomiris, C. (2011, September). The last trillion-dollar commitment: The destruction of Fannie Mae and Freddie Mac. AEI Outlook Series, American Enterprise Institute for Public Policy Research, Retrieved February 6, 2011 from http://www.aei.org/outlook/28704.

FIGURE 1

CHARACTERISTICS OF FANNIE MAE LOANS HOLDINGS
(June 2008)

Portfolio        UPB     Weighted   % FICO   Estimated %     %OLTV
Component      Billion   Average      <      FICO < 660 *   > 90% **
                 $s        FICO      620

Overall Book    2,667      722       4.8         15.6         10.4
Alt-A            307       719       0.7         7.2          5.4
Subprime          8        622       48.4        77.7         7.8

Portfolio      % Weighted   % of UPB
Component       Ave OLTV

Overall Book      71.8        100
Alt-A             72.8        11.5
Subprime          79.3        0.3

* Assumes a normal distribution of FICO scores

** Original Loan to Value

Source: Fannie Mae, 2008 Q2 10Q Investor Summary, August 8, 2008

FIGURE 2
CATEGORY PERCENTAGES RELATIVE TO UPB OF LOANS ACCUMULATED 2005-
2007 (Fannie Mae with duplications)

Loan Characteristic         UPB (billion $s)   UPB (billions
                              Accumulated         $s) Not
                               2005-2007        Accumulated
                                                 2005-2007

Negative amortization             11.9              7.2
Interest-only: *                 181.3             35.1
FICO scores less than 620         73.3             54.1
FICO < 620 & OLTV >              171.9             105.3
  90%
Loan-to-value ratios >            20.5              8.7
  than 90
Alt-A *                          224.1             82.9
Subprime *                        6.3               1.7
Jumbo Conforming                  0.3               0.6

Loan Characteristic           Relative     Overall
                             Difference     % of
                            2005-2007 to     Q2
                             Prior and      2008
                             Afterward       UPB

Negative amortization           0.65         0.7
Interest-only: *                4.17         8.1
FICO scores less than 620       0.35         4.8
FICO < 620 & OLTV >             0.63         1.1
  90%
Loan-to-value ratios >          1.36        10.4
  than 90
Alt-A *                         1.70        11.5
Subprime *                      2.83         0.3
Jumbo Conforming               -0.55          0

* including private label exposure

Source: Fannie Mae, 2008 Q2 10Q Investor Summary
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Author:D'Itri, Michael; Littlefield, Jon
Publication:Competition Forum
Date:Jan 1, 2014
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