Thoughts about our National Pastime and occasional thoughts for the Good and Welfare of the Reader (and maybe the writer)

Saturday, April 4, 2009

Detour into the Economics of the Mortgage Market Part I

Spring training is over, the 25 man rosters are set and opening day looms. For me, it will be Monday and a not sold out Dolphins (a football team) Stadium. So, let's turn our attention to the other hippo in the room – the housing market and its real estate lending companion, the mortgage.

I have been, from to time, critical of both Fannie Mae and Freddie Mac. So it is fair to discuss this further. After all, spring training have wound down but the economy is still wound up.

My biggest question, the one I keep trying to focus on is that since the US government has taken over both Fannie Mae and Freddie Mac why there isn't more discussion of merging them. In other words, what economic justification exists for the maintenance of a duopoly?

Both started out as government agencies and later evolved into what are known as government-sponsored entities. They have formal names – The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. They do the same thing. Before the housing holocaust, between them they control close to 90% of the secondary market for mortgage loans. In fact, I once in a meeting at Fannie's headquarters when the topic of competition came up. I was told that they measured their market share against Freddie, and they try to maintain it at 55%. I asked what about other competitors? I was told that they were only concerned about maintaining the balance between them and Freddie because otherwise people might wonder if Freddie shouldn't be merged in with the.

I asked what would be wrong with that – this was in about 1998. I was told that it is what it is. And, the very next day my project supervisor was told to take me off the project. The reason given was that I was asking irrelevant questions and probing in the wrong areas.

Fannie Mae is the older and is a creature of the depression. It was designed by the Roosevelt administration to support a mortgage market that was being stressed by the second of the two depressions of the 1930s. The idea was similar, but different, from what is being discussed today. In the Great Depression, unlike today, the federal government did not try to monetize the bad loans. What I mean by that is that banks were permitted to fail and money went out of circulation. It was not that banks would not lend, it was that they could not lend because they had no free capital with which to lend.

Factoring into the equation, although the mortgage loan existed, retail banking as we know it did not. Most commercial banks focused on business accounts and business loans. Consumer lending was the province of mutual savings banks, the brand new savings and loan association industry, and the predecessor of today's credit unions – known as building and loan societies.

Home ownership, nevertheless, was woven into the DNA of the United States. From its inception, people strove to own land, to build homes in order to provide shelter for their families. Canada, our neighbor to the north, achieved its expansion through mercantilism. Led by the Hudson Bay Company, land was acquired by enterprises and then parceled out to the workers and farmers they needed. In the US we expanded through movements like the Free Soil Party. We opened new territories and encouraged people to strike out for the west and claim their space.

When the Great Depression hit and people had to surrender their homes, The Roosevelt Administration set a goal to restore widespread homeownership. Fannie Mae was created to put mortgage funds into circulation by buying mortgage loans from lenders who were loath to carry loans on their books for the long terms that existed for mortgages. There will be more about that later.

In 1968, the LBJ administration privatized Fannie Mae chartering it like any other bank with a few notable exceptions. Fannie Mae did not take deposits and it did not lend directly to the public. Instead, it continued to function by buying loans. To finance Fannie Mae, the charter permitted it to issue bonds, secured by the mortgages it was buying and carrying the implicit guarantee that the US government stood behind those bonds. Why did LBJ do this? He needed to relieve the pressure on the federal debt ceiling because he was financing the war in Vietnam.

Two years later, in 1970, the US government (we are now in the Nixon administration) created Freddie Mac. It was an exact duplicate of Fannie Mae. It did exactly the same thing and it was funded exactly the same way – bonds, carrying a more or less government guarantee. The reason given at the time was that economic growth had expanded home ownership and the mortgage market to such an extent that Fannie Mae would be too large if allowed to function as a single entity.

What happened next is the story of the housing market, compounded by inexplicable decisions by the management of both GSEs.

Tune in next time for Part II of this too big to fail saga.

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