• Baltimore City Paper

Primer on the Federal Bailout of Fannie Mae and Freddie Mac

Who are Fannie and Freddie?:

Fannie and Freddie are private corporations implicitly (until Saturday; now explicitly) backed by the federal taxpayers. Congress chartered both companies (Fannie in 1938, Freddie in 1970) to "create liquidity" in the mortgage market.


What's Liquidity?:

When you borrow $200,000 to buy a home and promise to pay that back over 30 years, your lender has to hand over $200,000 in cash to the person you bought your house from. Lenders only have so much money on hand, so to get more money to lend to the next mortgage customer, they sell your loan to someone else. Fannie and Freddie were created to make sure that "someone else" would always be there--especially for loans to first-time buyers and people without a lot of cash to make a down payment.

So first-time buyers are to blame for Fannie-Freddie's collapse?:

Not really. Fan-Fred for many years maintained high standards for their loans. They refused to buy high-cost "subprime" loans, for example, and declined loans made to people who did not document their income. That changed, however, in 2006 and 2007, when new management lowered Fan-Fred's standards in order to regain market share after an accounting scandal.

Accounting scandal? Market share?:

Remember, Fan-Fred were private corporations, with shareholders, grossly overpaid CEOs, a short-term, quarterly results outlook and all the other trappings of corporate America. They also employed a huge corps of lobbyists in Congress looking out for their interests. Fan-Fred were attacked for years by the major banks--CitiGroup, Household Finance, Wells Fargo--who wanted to undermine Fan-Fred's public purpose. The big banks argued that Fan-Fred enjoyed an unfair competitive advantage over Citi and other banks, because they could borrow money more cheaply. The banks were right about that, but they also argued that Fan-Fred's providing "liquidity" was no longer necessary, as the private market had lots of other buyers of mortgage-backed securities. That was only true temporarily. Fan-Fred responded by amping up their returns to stock-holders, in part by

. After Fan-Fred were caught, they tried to come back by joining those big banks in the high-yield subprime and Alt-A mortgage markets. They did this just as both of those markets were collapsing.

Why did subprime collapse?:

Essentially it was a

. The subprime mortgage industry was created to make money on people previously judged uncredit-worthy, by collecting huge origination fees, high interest and prepayment penalties from them and/or refinancing their loans every year or two--a process known as

Foreclosures were an

, but served to keep the cycle of lending (and fee-collection) going. Things changed in the early 2000s when the subprime industry combined with a new industry called Alt-A to turbocharge the housing market. After the dot-com bust, millions of ambitious people left an uncertain job market and falling real wages to become

mortgage brokers and realtors working on commission. These people (many of them with "prime" credit) took advantage of new "Alt-A" mortgage programs that did not require them to

. They bought two, three and four homes at a time in a frenzy to


them for profit. The rate of foreclosures dropped as house values inflated to double, triple and even

, enabling even subprime borrowers to refinance easily and even take "cash out" of their homes. This investor class, folded into an already-bloated

, created a market in which each new "investor" had to locate a "greater fool" to overpay still more for each house. Collapse was inevitable as soon as the supply of fools ran out.

So, everyone who bought a house in the last two or three years was a "fool?":

"No one in this world, so far as I know, has ever lost money by underestimating the intelligence of the great masses of the plain people." --H. L. Mencken

But why didn't anyone see this coming?:

A lot of people saw this coming, but most of them were nobodies--


, old-timers in the real estate business who remembered the last real estate bust, way back in 1989. Most of the people running the finance industry and the real estate flip businesses were younger than 40--too young to know much about the business cycle, and very pleased to be earning $10,000, $20,000, and sometimes more each month just by borrowing lots of money and flipping houses, or making

unless housing prices could somehow increase 20 percent per year in perpetuity. Economists mostly went with the flow of

as is their habit. The bankers and lenders--many of them old enough to know better--put their faith in mathematical models of "risk management" and sophisticated new forms of "insurance" which were supposed to protect them if too many loans went bad. Such "financial engineering" systems proposed that, when packaged in new and unique ways, even bad investments could pay off at 10 percent per year.

But that's absurd! Can you prove what you say?:

Yes, but it'd be better for you to find out for yourself. For an overview of the markets in general, head to

blog, paying special attention to any post by Tanta. If you want insight into the mindset of the financial engineers, lurk around on

. "Quants" are the financial engineers who create products based on computer models. Their ranks exploded with the rise of hedge funds, which are otherwise known as unregulated pools of rich peoples' money seeking monster returns and zero risk--a logical fallacy. Hedge funds, Bear Stearns (the investment bank that imploded a few months ago) and Fan-Fred all used the same kinds of

to pretend they'd outsmarted the universe. If you want to "geek out" a little on just why the entire quant-based system of financial engineering might--just might--be a complete fraud, download the academic paper titled

You could also pick up Yale Economist Robert Shiller's


The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About it


But if you're right, collapse was inevitable. Are these people stupid?:

To the contrary: the people who dreamed up these new financial products and staffed these hedge funds were far from stupid. They're


, and we're the ones paying for their mistakes.

Why should we pay for the mistakes of financial hotshots, "quants," and Fannie and Freddie?:

Because that's the American system. We have "capitalism," which reveres and rewards "risk-taking," until the risk-takers screw up, and then we have


Why should anyone take your analysis seriously? Aren't you just a loser alt-weekly reporter making, like, $25,000 a year or something?

: Yes, I am a loser alt-weekly reporter with relatively low income and no expert credentials. However, I did predict this problem nine years ago,



So what happens now?:

We taxpayers give $200 billion (at least) to Fan-Fred while the overall market loses another trillion dollars (at least) of false value. Home-sellers will remain squeezed between falling values and (for many of them) large mortgages. Given that U.S. debt is already at unprecedented and untenable levels, it is possible that the U.S. will default on its debt-triggering a global financial crisis that would make the Great Depression look like a friendly game of Monopoly. Option "B" is that U.S. central bankers will allow inflation to reduce the value of the dollars paying down all this debt, which would also wipe out anyone who had any savings or investments denominated in dollars, and probably destroy the dollar forever as the main international currency. Plan "C" appears to revolve around a faith-based denial of basic reality, which should surprise no one who has paid any attention to public events during the past eight years. Praying certainly can't hurt.