By The Wall Street Journal
Washington is a place where bad ideas go to live forever. How else to explain the latest innovation from federal regulators to keep Fannie Mae and Freddie Mac dominating the market for mortgage finance?
Prior to the financial crisis of 2008, these two government-created behemoths owned or guaranteed more than $5 trillion in mortgage debt. When the housing boom went bust, taxpayers were forced to provide a $188 billion bailout to the toxic twins—and endure an historic financial crisis. So the taxpayer interest is in shrinking and eventually shutting down Fan and Fred.
But these days the Federal Housing Finance Agency that supervises the twins under federal “conservatorship” seems to view itself as the official preserver of Fan and Fred’s market share. So instead of simply telling the mortgage giants to stop buying and guaranteeing so many mortgages, the regulator has been encouraging the use of ever more complex financial instruments to keep Fan and Fred at the center of this multi-trillion-dollar market.
One Fan and Fred innovation—check your wallet when that word is used in government—is to use synthetic collateralized debt obligations (CDOs) to offload some of the mortgage risk they are holding. These new instruments are essentially a way for the mortgage giants to buy insurance against the possibility that lots of mortgage borrowers don’t repay the money they owe. But how about simply not holding these risks in the first place? Then taxpayers would have no need for insurance.
Fan and Fred are selling the CDOs to private investors, who are getting compensated with juicy yields in return for theoretically accepting much of the default risk in Fan and Fred’s bundles of mortgages. The program is ramping up and now covers at least some of the risks on more than $800 billion in mortgages of the more than $4 trillion that Fan and Fred still own or guarantee.
Since the two companies are backed by the government and can borrow money at rock-bottom rates, there’s not much incentive to create this kind of instrument—except a political one. For the toxic twins and their regulator, it’s a way to claim that they are reducing taxpayer risks and dissuade independent-minded politicians who might be tempted to enact significant reform—such as by shutting them down.
You won’t be surprised to learn that investors have been more eager to take on mortgage risks via these new Fannie and Freddie securities than via private mortgage-backed bonds, a market that has hardly revived since the financial crisis.
Why would investors rather deal with Fan and Fred than with a private seller of mortgage risk? Well, it could be because the Beltway geniuses who brought us the housing crisis are so much better at selecting quality mortgages and managing credit risks than private firms. Or could it possibly be that investors prefer having Uncle Sam standing behind the deal? When housing mania turns to financial panic, history shows that Washington will protect debt investors who buy paper from Freddie or Fannie no matter what the companies claimed beforehand.
We have the scars to prove it. An implicit taxpayer guarantee was at the heart of Fan and Fred’s last catastrophic experiment mixing public risk with private reward. When we and a few others noted that these risk-taking mortgage giants were offering an implicit federal guarantee that taxpayers might someday be called upon to redeem, Fannie Mae executives denounced us.
Everyone from Countrywide Financial’s Angelo Mozilo, the subprime mortgage maestro, to progressive godfather Barney Frank also dismissed the warnings. A Wall Street-Washington axis deceived taxpayers so Fannie and Freddie could keep peddling their paper as safe as Treasurys with a better yield.
And now the toxic twins are again selling paper that they claim is not backed by taxpayers. Freddie’s website says its new “Structured Agency Credit Risk” debt notes are “unsecured and unguaranteed bonds.” Fannie’s website promises the same and says its “Connecticut Avenue Securities” are part of a larger “Credit Risk Sharing” initiative “to reduce the government’s participation in the mortgage market.”
That’s Connecticut Avenue in Washington, D.C., by the way, which is apt. Taxpayers have learned the hard way not to believe a word on this subject from either government-sponsored enterprise—or their political patrons. But you’ll be happy to know that investors are enjoying fat returns while the toxic twins get political cover to continue their central role in mortgage finance. And the Beltway crowd wonders why Donald Trump is winning.