FIN 180/183 The real estate lending story, Part 7 Moral hazards, unintended consequences, and the secondary mortgage market (circa 2008 to present)

Continued from Part 6.

Before we discuss what went wrong with the secondary mortgage market, let’s review some past headlines related to Fannie Mae.

Study finds ‘extensive’ fraud at Fannie Mae (The Washington Post, May 5, 2006)

http://www.washingtonpost.com/wp-dyn/content/article/2006/05/23/AR2006052300184.html

Scandal to cost ex-Fannie Mae officers millions (The New York Times, April 19, 2008)

http://www.nytimes.com/2008/04/19/business/19fannie.html

Congress and the Countrywide scandals (WSJ.com, June 18, 2008)

http://online.wsj.com/article/SB121375337067183049.html

Fannie Mae, Freddie Mac spent millions on lobbying (USA Today, July 17, 2008)

http://www.usatoday.com/money/companies/2008-07-17-fannie-freddie-lobbying_N.htm

As you can see, Fannie Mae had its share of accounting scandals and corporate fraud.  Although corruption and these headlines did not help the situation, these stories were not the fundamental problem with Fannie Mae that led to a $60 billion bailout ($110 billion if Freddie Mac is included).  (See http://thegovmonitor.com/world_news/united_states/fannie-mae-gets-another-15-billion-in-taxpayers-dollars-14471.html)

Similar to the S & L crisis of the 1980s and early 1990s, this contemporary real estate finance crisis comes down again to moral hazards and unintended consequences.  To better understand the situation, we need to understand the environment including the politicization of American homeownership.  Homeownership rates and access to mortgage money are not left to free market forces but are political hot buttons as Democrats and Republicans alike want to tout high homeownership rates and low mortgage interest rates during their tenures. We could go all the way back to the 1930’s and the New Deal legislation, but let’s at least jump to the 1970s.

In 1977, Congress passed the Community Reinvestment Act (CRA).  The CRA was enacted to increase lending in inner cities by requiring banks to open new branches in these areas and maintain a certain percentage of their lending portfolio with small business and home mortgage loans in these areas.  Failure to maintain this CRA ratio resulted in limitations in opening branch offices in other non-distressed areas.

In 2002, the Single-Family Affordable Housing Tax Credit Act was legislated and would give $2.4 billion in tax credits to investors and builders to develop affordable single-family housing in distressed areas.

 

In 2003, a new program called the American Dream Down-Payment Act was established to help homebuyers with down payments and closing costs.  This program cost taxpayers $200 million per year to 2007.

These legislative examples are just one aspect of government involvement in real estate markets.  The government also encourages homeownership through the mortgage interest deduction on the primary, and sometimes second homes, residence for Federal income taxation.  Government is indirectly involved in real estate markets through the Federal Reserve, which has influence on interest rates and monetary policy, and Fannie Mae (as well as Ginnie Mae and Freddie Mac).

With special ties and implicit government backing, Fannie Mae did not act ‘normally’ and responsible in some cases.  Rather than focus on a competitive global business environment, Fannie Mae got involved with special government encouraged programs and took on many risks that they probably would not have taken without implicit government backing.  Also, many shareholders did not act cautiously and appeared to treat Fannie Mae as a relatively low risk investment. Similar to the moral hazard created by the explicit FSLIC government insurance on S & L deposits, implicit government backing of Fannie Mae created a moral hazard that led to suboptimal behavior by Fannie Mae management, investors, and the government.

A second moral hazard concerns the overall concept of a secondary mortgage market, rather than Fannie Mae specifically.  Again, the positive aspect of a secondary mortgage market is liquidity and the diffusion of locally concentrated credit risk.  However, credit risk did not disappear, it was just reallocated and dispersed to investors globally, in most cases to investors who had no understanding of the underlying US mortgage investments. 

The secondary mortgage market promoted a system where loan originators had strong incentives to close deals and collect origination fees, then pass the credit risk along to the secondary mortgage market.  This moral hazard, combined with government incentives and encouragement to increase the homeownership rate for all, led to the expansion of the subprime mortgage market and the creation of a wide-range of interesting loan products such as negative amortization, payment options, interest only (back again), and low or even no-documentation loans (called liar loans for short).

With the now explicit government backing of Fannie Mae, we realize that Fannie Mae’s credit risk was really born by US taxpayers.  This is clearly evident by the painful $110 billion, so far, taxpayer bailout.