The Fall and Rise of Fannie and Freddie: Securitization after the Meltdown

Abstract

This article analyzes the rise and fall of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Owners Loan Corporation (“Freddie Mac”). It explains why they should be revived, and suggests regulatory measures under which they can go forward on a sound basis.During the New Deal, the Administration and Congress perceived a need for a secondary market for mortgages, which had existed during the 1920s but collapsed with the 1929 crash. The market enabled mortgage originators to sell their mortgages, sometimes packaged into mortgage-backed securities, providing them with cash to lend to new borrowers. Congress attempted to fill this niche in housing finance by creating Fannie Mae in 1938.In 1966 Fannie Mae reinvented mortgage-backed securities to help finance the Vietnam War. These mortgage-backed certificates were so successful that Fannie Mae was divided in 1968 into the Government National Mortgage Association (“Ginnie Mae”), which remained a government agency, and the continuing Fannie Mae, which was privatized. In 1970, Freddie Mac was created, and also engaged in buying mortgages and packaging them into mortgage-backed securities.Both enterprises lacked meaningful regulation. They were not required to register with the SEC until after accounting scandals in 2002 showed that they needed oversight. They lacked even internal supervision until the Office of Federal Housing Enterprise Oversight (“OFHEO”) was established in 1992-but OFHEO was understaffed and weak. Outside auditors also failed to draw attention to major accounting problems.The lack of regulation was compounded by political pressures on both organizations to lower their standards to make housing more accessible. Originally, they would accept mortgages only with at least 20% down payments, but this fell to 3% by 2000. After the 2000, standards fell further as the associations began to purchase “subprime” loans with little prospect of repayment. When these loans began to default, both were unable to continue business as usual, and were forced into conservatorship.Conservatorship raises the question of whether Fannie and Freddie are necessary, or should be liquidated. This article argues that they are necessary. Experience has shown that purely private secondary mortgage markets are more sensitive than other securities markets to economic downturns-just when they are most needed to keep mortgage originating institutions lending. Moreover, the sheer volume of mortgages securitized by Fannie and Freddie-more than half the market after 2000-indicates that private securitization alone is insufficient.This leaves the question of how Fannie and Freddie should be regulated to keep them from relapsing after they leave conservatorship. The answer is effective regulation. This should have several key elements: (1) It must take into account the special characteristics of mortgage-backed securities; (2) it must provide minimum standards for capitalization of Fannie and Freddie, the characteristics of the mortgages they are permitted to buy; (3) there must be an outside financial regulator such as the Federal Reserve to enforce the regulatory rules; and there must be transparency both at the institutional level and in connection with the mortgage-backed securities to be sold, that can best be provided by the SEC.