Federal Home Loan Mortgage Corporation and the Housing Crisis - Essay Example

Federal National Mortgage Association, (FANNIE MAE), Federal Home Loan Mortgage Corporation (FREDDIE MAC) and the Housing Crisis Introduction Fannie Mae was formed in the year 1938. This was part of a deal by President Roosevelt. Private lenders had shied away from making any investments in the home loan market during and shortly after the Great Depression. This led to the national housing market collapsing, necessitating the creation of Fannie Mae. The main aim of establishing Fannie Mae was to give local banks money to finance home ownership. This was done in order to encourage and therefore increase owning of homes and to avail affordable housing. During its initial stages Fannie Mae’s operations were more or less like those of a national savings and loan. It allowed for banks charging low mortgage interest rates to encourage anyone interested in buying a home. It led to the creating a secondary market for mortgages. In this market, companies like Fannie Mae borrowed money from foreign markets at minimal interest rates since they were financially supported by the US Government. This enabled Fannie Mae to give fixed rate mortgage that have a very low deposit to any home buyer. Fannie Mae monopolized the secondary market for the first thirty years after its inception. In 1968, the Vietnam War created great fiscal pressure. This led to Fannie Mae’s privatization and its removal from the national budget by President Johnson. This is when it started to operate as a Government Supported Enterprise, GSE. It made profits for its shareholders and at the same time enjoyed being exempted from tax and oversight, despite being backed by the government. To prevent any further monopoly, another Government Supported Enterprise was formed in 1970. It was known as Freddie Mac. These two companies currently command a 90 per cent of the national secondary mortgage market. GSEs have experienced great growth financially over the years. Their combined asset base is currently at 45 per cent more than those of the biggest bank in the country. However, their combined debt equals 46 per cent of the present national debts. This high growth as well as over-leveraging has caused concerns in the Congress, the SEC and the Justice Department regarding their financial practices. Freddie Mac and Fannie Mae happen to be the only corporations in the Fortune 500 league that do dot abide by the requirement to furnish the public about any difficulties in finances they undergo. In case they collapse, the taxpayers will have to foot the multi-billion dollar outstanding debt. A recent probe into Freddie Mac by the SEC and the Justice Department discovered accounting errors to the tune of $4.7 billion, resulting in the dismissal of several top managers (Alford, 2003). Evaluation The GSEs’ role in the crisis and reasons for their current financial difficulties Various reasons have been attributed to the current situation of Freddie Mac and Fannie Mae. They include: The home owners’ inability to pay for their mortgages Poor judgment by both the GSEs and borrowers Speculating and overbuilding High-risk mortgages Government regulation or lack thereof. Federal Reserve policies Complex financial innovations that distributed and concealed default risks During high growth, increasing capital flow and great stability, market participants only concerned themselves with high yields forgetting about any risk involved. They did not properly exercise diligence. Other factors believed to have caused this situation include: Weak underwriting standards Unsound managing of risk The complicated and opaque financial products Excessive leverage that creates vulnerabilities in the system Supervisors, regulators and policy makers did not adequately acknowledge and address risk accumulating in the financial market. They also failed to be at par with financial innovation and regulate the domestic financial market. GSEs are limited by their charters to buy only buy family home mortgages that others originate. They are not entitled to diversifying their products. This greatly exposed them to both mortgages and housing market challenges. The other financial institutions have alternative investment options and are therefore shielded from such a crisis. In addition, Freddie Mac and Fannie Mae had a special relationship with the government, commonly referred to as an “implicit guarantee.” This relationship allowed them to access credit at rates slightly higher than what the federal government pays. Moreover, these two companies were operating with a high leverage. Their profit maximization came from striving to keep their capital reserves very close to the minimum allowed by the regulation authorities. Unlike other financial institutions, they were only allowed to buy mortgages made by others. Despite all these inhibitions, these GSEs were still subject to a law and regulator requirement of maintaining a certain ratio between their reserves and lending to protect against losing loans. Another important component of reserves was the shareholder equity. Government intervention measures In 2008, the US credit crunch became Wall Street’s biggest crisis only comparable to the Great Depression. Many multi-billion dollar investments into the mortgage industry failed to materialize. Giant investment banks as well as commercial banks experienced a decline in performance and had to reinvent themselves. The country’s biggest insurance firm and biggest savings and loan firm were all seized by the government. The government adopted a $700 billion plan to help in bailing out these GSEs and give reassurance to the market and restore credit flow once again. However, this crunch started spreading to Europe and emergent markets. The government scrambled to help in propping up banks, broadening deposit guarantees and agreeing on a response with proper coordination. In 2007, there was an announcement to the effect that the government would be taking over Freddie Mac and Fannie Mae. Similar efforts to salvage the bankrupt Lehman Brothers failed and it collapsed. In the same month, an insurance firm AIG was on its death bed due to exposing itself to exotic securities commonly referred to as “credit default swaps.” The Federal Reserve helped in its bailing out in an eighty-five billion dollar deal. Its stocks still dipped by nearly five-hundred points. Anxiety in the stock market eased only when the government proposed a $700 billion bailout. The government announced that it would purchase all the dangerous assets from these banks. The move was meant to shore up balance sheets and restore confidence in the financial system. This plan was however amended by the Congress to include provisions for limits on executive remuneration, oversight and the option of the government becoming a stakeholder for all companies bailed out by it. This infuriated a number Americans. They believed taxpayers’ money should not be taken to Wall Street Banks since they caused this financial crisis in the first place. Legislators who strongly believe in free markets were also up in arms against this plan. Their argument was that it was not any different from socialism. The bill was initially rejected leading to more amendments where a few tax breaks were included as well as a few other additions. This revised version was easily passed by the senate and Congress did the same afterwards. After the passing of this bill, it was still not clear how effectively this plan would resolve the credit crisis. Many economists and analysts were of the view that it would only offer temporary aid. On its part, the Federal Reserve made a promise of increasing regulation of the financial sector. The initial reactions of this bailout were not positive. It appeared that many banks in Europe had pumped in heavy mortgage-based investments at Wall Street. Moreover, England had also experienced bust and boom in the mortgage industry. This combination of factors posed great danger to many institutions in Europe. The government of Germany also made a move guaranteeing private savings in the country. It also promised to arrange bailouts for a big lender in the country who is a vital financial company in Europe (Robinson, 1990). As the US started executing the bailout plan, there was a continued change in tactics. The treasury made an announcement to the effect that it was going to use part of the funds in buying commercial paper. This is an important short-term borrowing for businesses to help in the resumption of credit flow. Recommendation The Congress should address this credit crunch with simple amendments to the Securities and Exchange Commission (SEC) rules. Despite there being a credit crunch, many banks are still doing fine. This amendment should ensure that Congress takes swift and less cumbersome steps to enable the financial markets return to order. Then the housing crisis can be resolved. Fannie Mae and Freddie Mac have no option but sell a portion of their mortgage portfolio to settle their debt. However, fear of default risk has reduced the existing mortgage’s market value. Fannie Mae has a comparatively more impressive credit quality but OFHEO has questioned the credit quality of Freddie Mac (Sprague, 2000). The 700 billion dollar bailout plan will not solve the problem. This money should instead be channeled towards refinancing troubled mortgages. If there is no default in mortgages, income flows from their interest to the owners of mortgage-related securities will be restored. This will have solved the solvency problem of the securities. The financial market must also be regulated very carefully. It should not be over regulated or wrongly regulated. The US should address its trade and budget deficit to help in shoring up confidence in its treasury. The US can do away with its deficit by stopping wars and cutting down on military expenditure. This military expenditure is unaffordable Trade deficits are hard to reduce. This is because the US depends on imports of energy and manufactured products that include advanced technology. The offshore production of US products meant for its market should be brought back into the country. This will go a long way in solving the problem of trade deficit. Prudence must be exercised in issuing credit cards by checking on credit history, income and employment of the applicants. Fractional reserve banking should be intervened by placing a greater reserve requirement by about double the current one. The government should not meddle in the financial markets. Government intervention distorts the market and then reacts by imposing new regulatory laws that cause more distortions and the cycle continues. The government must also reduce regulations on banks and other financial institutions that could cause the financial sector to be rigid. Excessive government meddling could lead to future financial crises. Bailouts are excessive economic intervention by governments. By bailouts, the government is not giving markets a chance to adjust prices. They only lead to an increase in financial instability. Government bailouts, although have good intentions, have diminishing impact. The latest bailout in the US for instance has in reality had the opposite of what was desired especially on stocks. This has shown that government bailouts are insignificant and unwarranted (Paul, 2008). Since increased money supply is the root cause of the boom, it results in mal-investment and allocation of resources in low demand sectors. On this realization, the builders resort drastic measures such having the prices lowered. This returns the economy back to balance, to a state of equality between demand and supply. This adjustment creates situation where affordable housing can be found without seeking for mortgage products. This really hurts the real estate industry players. The government tries to keep the prices artificially high. This was the cause of the Great Depression. This should be avoided by all means. By bailing out Fannie and Freddie, purchasing AIG and the $700 billion scheme, the government wants to prevent liquidating of bad debts. These actions end up encouraging a moral hazard. This sets precedence for financial institutions to engage in even riskier businesses because they are assured of a government bailout. This will lead to financial system instability in the future. The US government should have left market correction mechanisms to take their natural course. Government regulatory agencies are the ones to learn a few lessons here and there to avert any future crises. References Alford, R (2003) .What are the origins of Freddie Mac and Fannie Mae? Retrieved from www.hnn.us, on November 19, 2008 Paul, R. (2008). Bailouts will lead to rough economic ride, retrieved from www.cnn.com, on November 6, 2008. Rabel, R. G. (2002).The American Century? In Retrospect and Prospect. Greenwood Publishing Randazzo, A. (2008). Economy in the balance: How the bailout is polluting our financial future, retrieved from www.reason.com/news/show/129202.html, on November 6, 2008. Robinson, M. A. (1990).The Bailout of American Savings-Dutton Sprague, I. (2000).Bailout: An Insider’s Account of Bank Failures. Beard Books. Read More