Fannie Mae and Freddie Mac: A Study in Unintended Consequences

Treasury Secretary Timothy Geithner’s recent announcement of a plan to eliminate the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation - affectionately known as Fannie Mae and Freddie Mac – included a shocking admission.

Speaking of the federal government’s overwhelming involvement in the U.S. mortgage industry, Geithner said "I think it's absolutely the case that the U.S. government provided too much support for housing, too strong incentives for investment in housing. We just took that too far."

Well, maybe this isn’t so shocking to anyone who followed the upward trajectory of housing prices from the early 2000s through 2006 and recognized the role easy credit played in both the birth and demise of the housing boom. After years of hearing politicians like our own Senator Bernie Sanders blame everyone but the government for the crash that led to our current bleak financial situation, however, it was satisfying to finally have public confirmation that Government-sponsored Enterprises (GSEs) such as Freddie and Fannie had played a large role in the financial meltdown.

Fannie Mae and Freddie Mac were set up forty years ago as mortgage securities brokers. They did not provide mortgage money directly but bought mortgages and mortgage-backed securities from banks and other financial institutions. Though technically private, they enjoyed government support in the form of lower interest rates than what were available to other lenders. They also received implicit assurance of federal assistance should they find themselves in financial trouble, which, of course, they did.

It was fun while it lasted – private lenders found a new pool of customers as people who should have been renting were encouraged to take advantage of creative financing options, many of which required little or no money down. These private financial institutions took on risky customers knowing the government-sponsored enterprises would gobble up the loan packages, thus providing the money to finance more questionable loans.

Freddie and Fannie were having a great time of it - borrowing at low rates the money to purchase these mortgage packages, making a tidy profit for themselves and their investors in selling, earning large salaries for management and even holding some capital, all the while allowing the federal government (that would be we, the taxpayers) to bear the risk.

Meanwhile, politicians of both parties raked in hefty campaign donations, especially from Freddie and Fannie, who over a decade spent almost $200 million in lobbying and contributions. The top three recipients in the Senate of Fannie’s and Freddie’s largess were Democratic senators Christopher Dodd, Barack Obama and John Kerry. This is important to note because it was Democrats such as Dodd and his House counterpart Barney Frank who blocked attempts by Republicans in early 2003 to investigate some funky accounting practices being used by the GSEs.

As often happens when other people’s money is at stake rather than one’s own, Fannie, Freddie, and their Washington enablers pushed things too far. The politicians saw an opportunity to make political inroads with yet another constituency group – the unhoused – and pressured lenders to provide mortgages to more and more people who, unfortunately, couldn’t really afford to own homes. In 2004 the Bush administration decreed that within four years, 56% of Fannie's and Freddie's mortgages should go to low-income households and 28% of the mortgages to those with a "very-low income." Rather than curtailing a lending strategy which made “sub-prime loans” desirable financial instruments, Congress pushed for even more aggressive lending. Old-fashioned requirements like down payments and even income were dispensed with in the effort to get every American into a house (or two or three) or his or her own.

Reality has a way of rearing its unwelcome head and did so in September of 2008. All those new customers who were brought into the housing market through easily obtained mortgages pushed up the cost of existing homes. High home prices encouraged immoderate new construction, which led to the overproduction of housing and, eventually, falling prices. Homeowners found themselves in foreclosure and many walked away from homes that were worth less than they owed. Fannie and Freddie found themselves in crises and were brought under government conservatorship. Estimates of what this will eventually cost American taxpayers range between 350 and 750 billion, though some say the total cost will reach into the trillions. This doesn’t include the inestimable effect on what should be a free economy when as large a player as the federal government decides to manipulate the market. The unintended consequences of government intervention in the housing market have become painfully apparent to all Americans, and all continue to feel the adverse effects.

The move to transition the U.S. mortgage industry away from government dependence is a good one. According to Geithner it will include reforms that will benefit both lending institutions and consumers, also good. Smoothing over government’s footprint in the housing market sand will take time, though, as it is wide and deep. Could we at least use that time wisely, study the lessons of Freddie and Fannie and apply them by keeping government out of enterprises where it really has no Constitutional right to be?

An Economy in the ICU

The Vermont economy is on life support and could slip into a coma without drastic changes in how our state government leaders approach their fiduciary responsibilities. This is the only conclusion a reasonable person can make after attending a presentation by Tom Licata, founder of Vermonters for Economic Health.

VEH is a grass-roots, citizen-led organization with a simple mission: to promote economic health and fiscal responsibility in Vermont. Its Web site can be found at http://www.vteh.org.

Licata's colorful graphs and pie charts juxtapose with his sobering fiscal facts to confirm what hardworking Vermont taxpayers already suspect -- that despite the incredibly high taxes we pay at every level of Vermont government, the coffers are empty. Well, maybe not quite empty -- they are actually full of IOUs.

In a nutshell, these are the facts we must face: Vermont has lived beyond its means for far too long. According to VEH's figures (derived from Vermont's Joint Fiscal Office), Vermont faces a $470 million shortfall in its general fund between 2011 and 2014. Astonishingly, between the years 2000 and 2007, state government payroll and employee benefit costs grew 70 percent, while inflation grew some 23 percent, a growth rate of roughly three times this inflation figure.

During this same time period, private-sector job growth was 0 percent. That's right, zilch!

This problem is also graphically illustrated in education finance policy. While Vermonters' incomes rose only 13 percent between 2005 and 2009, education property taxes rose 35 percent. Spending for K-12 education rose 23 percent, 200 percent over the rate of inflation. Even more frightening is this: over the next 20 years, Vermont faces billions of dollars in unfunded budget expenditures -- approximately $3.5 billion. The largest segments of these are made up of road and bridge repair, water system maintenance and upgrades, bonded debt and Medicaid shortfalls.

This $3.5 billion figure does not include $1.6 billion in unfunded teacher and state employee medical liabilities, nor does it include $466 million in unfunded pension liabilities.

"We have not saved and invested enough for road and bridge infrastructure or for retirees' pensions and health care," Licata said. "We've dug an enormous hole, and it's going to take a lot of work to get out of it." Especially since our fiscal rope is badly fraying. Most money for the general fund comes from income and sales taxes, Licata explained.

These revenues are shrinking as people lose jobs, investment income falls and a belt-tightening public consumes fewer goods and services. Also worrisome is the uneven distribution of tax liability -- about 5 percent of Vermont's tax filers pay about 50 percent of total income taxes. Redistributionists might applaud that figure, but remember this -- upper-income earners have the most resources and reasons to leave the state. If even a quarter decided to do so, Vermont's tax base would be devastated. Replacing these disappearing taxpayers from within seems unlikely.

Just prior to our recession, the state experienced no private sector job growth over this last decade. Since 2000, we have lost more than 10,000 manufacturing jobs while public sector jobs in health and education have increased by almost as much. Many of these jobs, of course, are sustained through tax revenue rather than privately generated wealth. Sadly, we are losing our young people at a rate of four times the national average.

Meanwhile, the number of retirees living within the state is expected to double over the next 25 years. The lack of revenue diversification is also illustrated in our reliance on federal government aid, which accounts for some 30 percent of our total budget. This kind of concentration of risk should keep those in Montpelier up at night, especially in light of our federal government's fiscal woes.

Next month Licata will be making his presentation to the Vermont Legislature in front of members of the House Ways and Means Committee and others.

Among other solutions, he will recommend spending limits and fiscal analysis of key legislation. He will also advocate for policy that creates a better atmosphere for creating jobs and thus expanding the tax base.

If you think your Vermont representatives need to hear this you might want to encourage them to be in Room 11 of the Statehouse on Jan. 6 at 2:30 p.m. for Licata's presentation. It's time our legislators get the facts and start using them in making decisions that affect us all.