The demise of Fannie

The quality that made it a favorite was also the quality that led to its demise. This raises the question whether a government backing is useful or useless. Shareholders always want higher profits. Higher profits mean higher risks. Higher risks means gambling. an interesting NYtimes article today describes the demise of Fannie Mae(and Freddie Mac). A listed organization, Fannie faced pressure from the shareholders. Government backing meant pressure from the senators as well. Who were the senators who blamed Fannie of not issuing riskier loans? With increasing hosuing prices, it became increasingly difficult for the low-income groups to buy mortgages. Democrats raised a ruckus and stepped up pressure on Fannie to buy riskier loans and issue it to the low-income group.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

Another problem came from the combined pressure from Countrywide FInancial and the investment banks on Wall Street. For years, Fannie had been the sole middleman for mortgages. Wall Street in search for higher return projects had turned to the sub-prime mortgage securitization. They started dealing with Countrywide directly eliminating the middleman Fannie. In addition, Countrywide was Fannie's biggest business partner. That putting too many eggs in one basket leads to grave situations, isn't rocket science. Countrywide issued an ultimatum to Fannie. Buy my riskiest loans or forget doing business with me. Fannie by then had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.

So Fannie bought this risky loans and being the "government backed" entity and the to further the purpose of its existence, Fannie kept the charges low as compared to the risk it was taking. When the bet went wrong, the mortgage insurer feared losing billions of dollars in guarantee. The same shareholders vying for the blood of the executives now were the ones who pressured Fannie to take more risk and increase their return on investments.

Had Fannie been a private entity, it would have been at liberty and also incentivized to get out of the mess. But the White House, Capitol Hill and Wall Street ignored Fannie. Being a government backed entity reduced its perceived risk of failure for weird reasons. Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply. “I’m not worried about Fannie and Freddie’s health, I’m worried that they won’t do enough to help out the economy,” the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time. “That’s why I’ve supported them all these years — so that they can help at a time like this.”

I feel that government backing is useful when it is practical and timed properly, as seen in the bailout. It is useless as seen in the case above. But, then there is always the case of moral hazard. And executive incentives. And politics.. The list goes on and on.

(Some of the extracts are as they are from NYtimes October 5 edition. Please refer http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=1&_r=1&hp for the complete article.)