Adventures of Freddie and Fannie in the Land of Make-Believe

FRFI 204 August / September 2008

Who are Fannie and Freddie?
‘Freddie Mac’ and ‘Fannie Mae’ sound like they should be characters out of a children’s cartoon. In fact they’re the leading financial characters in an absurd capitalist farce that will end in tragedy for the poor of the US. Both are US ‘Government Sponsored Enterprises’ (GSEs), also known as ‘agencies’. Freddie is the ‘Federal Home Loan Mortgage Corporation’ and Fannie is the ‘Federal National Mortgage Association’. Fannie Mae was founded in 1938, as part of the ‘New Deal’ – the program of state intervention to help rescue US capitalism after the 1929 depression. In 1968, to help balance the budget, part of Fannie Mae was taken off the government’s balance sheet and privatized. Freddie Mac was established in 1970 as a private corporation with a public charter to provide competition with Fannie Mae.

So today, both are privately owned corporations supposed to fulfil a congressional charter to ensure that mortgages are available for affordable housing. They do this by buying mortgages off banks. Banks and other institutions create a ‘primary market’, making home mortgage loans to home buyers. The agencies are part of a ‘secondary market’ – they buy mortgages which meet their standards, pool them together and sell bonds, using these ‘mortgage backed securities’ (MBS) as collateral.

Why are they so important?
The agencies play a key direct role in the mortgage markets, increasing liquidity by cycling mortgages into cash which the banks can then loan out again. They guarantee the mortgages and charge the banks a fee for the service. Since 1980 they have expanded to an enormous degree:

Agency Investments relative to US Residential Mortgage Market – $billions1


Total US residential mortgage market

Total agency mortgage investments and MBS

Investments as % of mortgage markets

















Without the agencies, the collapse in mortgage lending over the last year would have been even worse. In the first quarter of this year, they purchased more than three quarters of the total value of mortgages. If Fannie and Freddie seize up, then so will almost the entire residential mortgage

Although agency securities are legally private bonds, they have certain privileges compared with those of other banks. For example, they are free of State and local taxes. In law the agency securities explicitly have no government backing, but they are universally treated as if there is an implicit guarantee of government backing. Indeed the agencies imitate US Treasury bonds in the way they are sold and serviced, and deliberately imply, particularly to foreign purchasers, that they are just another government security. This perceived guarantee allows the agencies to borrow at the best rates.

Agency debt is held as prime investment by all the major US banks, which have treated them, at least until recently, as almost as solid as US Treasuries. Of the first quarter 2008 total of $4,594.6bn of agency debt (overwhelmingly from Freddie and Fannie), some $922.9bn was held by US chartered commercial banks, $517.8bn by insurance companies, $329.3bn by state retirement funds, $268.8 by private pension funds.  These securities form the collateral for a huge amount of lending, since, in the event of a default, they can readily be sold. Any slide in quality of agency debt will hit liquidity throughout the entire US banking system.

About $1,540.8bn of agency securities are held by foreign investors, about $1 trillion by official financial institutions like central banks,2 counting them amongst their reserves. Any increase in the risk of agency securities, or downgrading of their quality will have huge repercussions on government finances and economic policy throughout the world.

The balance sheet
Every investment institution needs to keep a certain amount of capital on its balance sheet to redeem maturing debt, cover defaulted loans, and handle unanticipated events – like the implosion of the US housing market.

The agencies only take mortgages where the value is no more than 80% of the value of the property and also require that they are covered by mortgage insurance. However, over half the loans they guarantee date from 2005-2007, when additional loans were being piggybacked on top of the main loan, eroding remaining values in the properties. Mortgage insurers have been hit hard and may not be able to cover all losses. And Freddie has bought substantial portions of the supposedly investment quality sub-prime MBS we have discussed in previous issues of FRFI. Estimates of potential losses by the agencies run as high as $100bn.

So, what do Freddie and Fannie have in their little piggy banks? Despite all the assurances we have heard to the contrary, they don’t have enough equity. As one analyst puts it: ‘Freddie is insolvent, Fannie is running on fumes’.3 On 31 March, by standard accounting rules, Freddie had $16bn of equity to support over $800bn of on-balance sheet loans. Buried in the accounts, this equity includes $16.6bn of deferred assets - which will only be realised if Freddie starts making money – without these future assets, which it may or may not receive, Freddie’s assets are minus $0.6bn, in other words, under water. In addition Freddie has $1.4 trillion held off its balance sheet. If Freddie’s assets are assessed at ‘Fair Value’ – an accounting term for current market value – their value plunges to a negative net worth of minus $5.2bn.

Fannie is better off, but not by much: when we compare equity with the mortgage credit ‘book of business’, Fannie’s equity covers 1.4%; Freddie’s just 0.7%. In a falling mortgage market, this is just not enough.

The Land of Make-Believe
For years the saner bourgeois commentators and analysts have pointed out the potential problems which are now surfacing. Some politicians have been trying to reform the agencies for years. So how come nobody fixed this problem?

The two agencies have loaded up the gravy train with some $20-25m every year, which then chugged round Washington, doling out bowlfuls in a massive lobbying effort for more than a decade. At its height Fannie used to spend $55m per year to maintain 55 ‘partnership offices’ in all but three states, now renamed as ‘community business centers’ whose job was to woo state legislators.4

Both presidential campaigns are infested with agency lobbyists:
‘Rick Davis, McCain’s campaign manager, was president of the Homeownership Alliance, which advocates the expansion of homeownership through low-interest mortgages funded by Fannie and Freddie. Arthur B. Culvahouse Jr, who is heading McCain’s vice presidential vetting panel, was a lobbyist for Fannie Mae.

‘Obama also has ties to the firms. James A Johnson, the former head of his vice presidential vetting panel, was a chief executive of Fannie Mae. Maria Echaveste, a top Clinton White House official whose husband Christopher Edley Jr is a close Obama friend and adviser, has lobbied for Freddie Mac.

‘Other Democratic luminaries who have advocated for the mortgage giants include... former congressman Harold E Ford Jr (Tenn), now the head of the Democratic Leadership Council.’5

As a result of this influence, the agencies have thwarted every attempt to bring them within the bounds of ‘sound’ capitalist behaviour. For years they managed to prevent investigation into fraudulent bookkeeping which cost the companies billions. This is how it has been able to keep $1.4 trillion exposure off-balance sheet. They have successfully tamed their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), so that by law, it satisfies statutory minimum capital requirements by holding enough equity to cover just 0.45% of this.

Indeed, their regulator seems to have actively joined the lobbying effort. Accounting rule FAS140, if applied, would force the agencies (as well as other financial institutions) to bring MBS onto the balance sheet. If that happens, the agencies will need $75bn additional capital, according to investment bank Lehmans. James Lockhart, director of OFHEO, immediately retorted: ‘an accounting change should not drive a capital change’. In other words, let’s keep playing ‘Let’s Pretend’.

Wherever these assets appear in the accounts and however they are valued, the fact remains that the agencies don’t have enough capital. They are operating a giant ‘Ponzi’ racket or pyramid scheme, which can only keep going as long as the money coming in covers that going out.

What’s the fix for this mess?
Raising private capital is going to be difficult because, with all the uncertainty, the agencies’ share price has collapsed, and nobody wants to throw good money after bad.

Some ‘socialists’ are demanding ‘nationalise the banks’.6 They are in excellent company with the more prudent sections of US finance capital: William Poole, former President of the St Louis Federal Reserve Bank, has also called for their nationalisation;7 Ben Bernanke, chairman of the US Federal Reserve told the US House Financial Services Committee: ‘There certainly are a number of possibilities ranging from outright nationalization, to privatization to breaking them up’.8 When the entire structure starts to creak, the ruling class as a whole has no hesitation about throwing some of its members to the wolves.

As the Wall Street Journal put it: ‘We haven’t suddenly become socialists. What taxpayers need to understand is that Fannie and Freddie already practise socialism, albeit of the dishonest kind. Their profit is privatized but their risk is socialized. We’re proposing a more honest form of socialism, with the prospect of long-term reform.’9

Yet instituting a ‘long-term reform’ – a regulatory system with realistic capitalization requirements and oversight – is not going to fix this problem. Even if it had been in place early enough, the only difference would have been how soon the problems came to light.

The only workable solution to the problem is to cancel all residential mortgages and to implement a housing program which ensures that people are housed on the basis of need, not wealth. But that would require a revolutionary movement, and that has yet to develop.
The Paulson plan

In the absence of any revolutionary alternative, finance capital has the initiative. Its representative, Hank Paulson, Treasury Secretary and parasite-in-chief, has devised a plan, now passed into legislation by Congress in record time. The measures give him authority until December 2009 to extend an unlimited line of credit to the agencies and to buy their stock, if conditions worsen. In an attempt to limit the hit to taxpayers, the ceiling on the national debt has been raised to $10.6 trillion. Currently the National Debt is about $9.5 trillion.

The Paulson plan is simply more ‘Let’s Pretend’: it just extends more credit, delaying the final settling of accounts, which will include US taxpayers – the working and middle classes – handing over tens, even hundreds, of billions of dollars to rescue finance capital.

While Fannie and Freddie have been the stars, finance capital continues its relentless slide down, helped by a full supporting cast. IndyMac bank, second largest bank in the US, collapsed; the FBI is investigating potential fraud. US Bancorp wrote off $16bn, Bank of America $1.2bn, JPMorgan Chase $1.1bn, Wells Fargo $2.9bn, Citigroup $14.2bn, Wachovia $6.1bn, Merrill Lynch $9.7bn, Washington Mutual $2.2bn, Countrywide $4.4bn. Senators Dodd and Conrad have been discovered to have received preferential ‘VIP’ terms on mortgages from ailing Countrywide mortgage bank. Grand jury subpoenas have been issued to Countrywide Financial Corp, New Century Financial Corp and IndyMac Federal Bank to investigate fraud and racketeering. Los Angeles is suing all the big banks, accusing them of anti-trust violations and defrauding taxpayers. Goldman Sachs, the one large bank to side-step the subprime crisis, has left the bank lobbying group Institute for International Finance, describing its attempts to ‘refine’ fair-value accounting as ‘Alice in Wonderland accounting’. Total US profits have been falling absolutely, along with housing prices. Unemployment and foreclosures are up. McCain’s economic adviser, former Senator Phil Gramm, architect of the deregulation which laid the basis for the credit crisis announced ‘this is a mental recession...We’ve never been more dominant’.10

In short, everything is normal in the Land of Make-Believe. m

Steve Palmer, US correspondent

1          Calculated from Working Paper 2006-2, Federal Reserve Bank of Atlanta, and US Federal Reserve Bank, Z1 Flow of Funds Accounts.
2          Federal Reserve, Z1. See also ‘Overseas investors take hard look at US mortgage giants’, International Herald Tribune, 21 July 2008.
3          Len Blum, ‘Fannie Mae, Freddie Mac Shares’, Westwood Capital, 14 July 2008.
4          ‘Fannie Mae dissolving grass-roots lobbying network’, Washington Post, 16 September  2005, page D01
5          ‘Figures in both campaigns have deep ties to mortgage giants’, Washington Post, 17 July  2008, pA06
6          See, for example, Mick Brooks, ‘Why you should worry about Fannie and Freddie’, In Defence of Marxism,
7          CNBC TV, 11 July, 2008.
8          Nightly business report, National Public Radio, 16 July 2008.
9          Wall Street Journal, 12 July 2008.
Washington Times, 9 July 2008.


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