Jim Jubak: Fannie Mae, Freddie Mac need to be dismantled

Jubak's Journal8/2/2010 8:00 PM ET

Fannie and Freddie must die

The taxpayer wards have gotten billions in bailouts in the name of preventing a mortgage meltdown and housing collapse. And now Congress is looking for a solution. Watch out.

By Jim Jubak

And now, fresh off passing the 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress promises to address the problems of Fannie Mae (FNMA, news, msgs) and Freddie Mac (FMCC, news, msgs).

Be afraid. Be very afraid.

Oh, not because Fannie Mae and Freddie Mac don't need to be reformed. They sure do.

And not because Congress can be counted on to compromise its way into a hash that combines the worst of private-market gestures with the worst of bureaucratic rule splitting.

No, the real danger is that a mistake in fixing Fannie and Freddie could take down the Federal Reserve. Or at least take down the Fed to the degree that any central bank, with a vgcentral bank's ability to create money, could be taken down.

Click graphics to see interactive charts

Fannie Mae
Graphical chart for FNMA
Freddie Mac
Graphical chart for FMCC
All hyperbole aside, a mistake in fixing Fannie Mae and Freddie Mac could throw the U.S. financial system into crisis again by destroying the Fed's balance sheet.

The two entities -- I don't know quite what else to call them now that the one-time government agencies turned publicly traded companies have turned into wards of the taxpayers -- played a central role in the housing bubble that led to the global financial crisis. By using an assumed government guarantee to raise cheap money from investors who persisted in thinking that so-called agency paper was like U.S. Treasury notes, Fannie and Freddie enabled mortgage lenders to pass on a riskier and riskier mix of mortgage paper to the financial markets.

Somebody else's risk

If you can pass on risk to someone else, the temptation to make more money by taking on increasingly greater risk -- for someone else -- is almost irresistible. Certainly, few mortgage lenders were able to fight the urge. The result was shoddy underwriting that, at its worst, wrote mortgages to any borrower with a pulse -- even if he or she didn't have an income, a credit rating as high as the mortgage banker's IQ or any real need for the money.

Now, as a result of the mortgage debacle and the global financial crisis, private mortgage lenders have pretty much stopped lending. In the first quarter of 2010, Fannie and Freddie -- plus Ginnie Mae, which had an explicit government guarantee even before the crisis -- guaranteed 95% of all mortgage originations in the United States. In other words, in the first quarter, Fannie, Freddie and Ginnie were the mortgage industry.

Or maybe, more accurately, U.S. taxpayers were the mortgage industry. The federal government took over Fannie Mae and Freddie Mac in 2008, and taxpayers now own about 80% of them.

What do we own? It's not pretty. Fannie Mae owns or guarantees almost half of the $10 trillion in outstanding U.S. mortgages. But at the end of the first quarter, Fannie and Freddie reported $330 billion in nonperforming loans. And that portfolio is likely to get worse before it gets better.

A lesson learned too late

In 2008, once the damage was done, Fannie and Freddie began tightening their standards for mortgages and raised the fees they charge to guarantee bundles of mortgages wrapped up into mortgage-backed securities. For example, in 2007, 10% of mortgages at Fannie and Freddie were for 95% or more of the value of the house. By 2009, that 10% had dropped to just 1%.

But the damage to the loan portfolios from pre-2008 lending practices is staggering. At the end of March, about 4% of the mortgages originated by Freddie Mac in 2008 were delinquent by at least 90 days. For mortgages originated in 2009, the figure was less than 0.1%.

That's swell -- except that Fannie and Freddie guaranteed a huge number of mortgages in the boom years of 2006 and 2007. Mortgages originated in those two years make up 24% of Fannie Mae's business, for example, but account for 67% of its credit losses.

So far, propping up Fannie Mae and Freddie Mac by providing them with the money to cover losses and stay in business has cost taxpayers $145 billion.

Estimates of the total cost to taxpayers come in all over the block because they're all based on guesses about when the U.S. economy -- and the U.S. housing market -- will improve and how fast that improvement will be.

The White House estimates a total bailout cost of $160 billion. (Let's see, we're at $145 billion, and defaults are accelerating for prime mortgages. I'll be kind and say $160 billion is unlikely. For more on the rising number of the "best" mortgages that are now going bad, see this post on my website.)

The Congressional Budget Office puts the cost at $389 billion (.pdf file) through 2019. Barclays Capital says the cost could rise to as much as $500 billion if housing prices fall by 20% from the levels of the end of 2009 and default rates triple.

The truth is that nobody knows exactly, but it'll be a big figure.

Continued: The rest of the problem 

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