St. Louis Beacon – Who are Fannie and Freddie and Why Are They Spooking Our Economy?

July 16, 2008

Originally published by The St. Louis Beacon on Tuesday, July 15, 2008:

By Paul Povse, Special to the Beacon

It’s virtually impossible to read or hear the news without Freddie Mac and Fannie Mae cropping up.

Freddie Mac and Fannie Mae are mortgage lending behemoths that own or guarantee nearly half of the mortgages issued in the United States. They buy mortgages, convert them into securities and sell them to investors. The mortgage foreclosure epidemic, sub-prime lending crisis and sagging housing market, coupled with other complex economic forces, all work against Fannie and Freddie.

But why do they have the attention of everyone from the president to the Treasury secretary to the chairman of the Federal Reserve Board to the young couple down the street pondering their first home purchase?

For straight talk and analysis about Freddie and Fannie, The Beacon turns to Robert Cropf, chair of the Department of Public Policy Studies at St. Louis University. An associate professor who also teaches a course in economics, Cropf helps to “untangle the thread of the complexity” of Fannie and Freddie.

Q: Why, Dr. Cropf, are Fannie Mae and Freddie Mac suddenly so prominent in the news?

A: You can’t overstate the importance of the companies that guarantee about half of the nation’s mortgages. If you go along with The Wall Street Journal, it adds up close to $5 trillion (the Fs own or roughly guarantee). They are particularly hard hit by the housing current mortgage foreclosures, which doesn’t seem to have an end point in sight.

Their shares are dropping like a lead balloon. The delinquency rate on their mortgages is rising as fast as their shares are falling, which is not a good situation to be in. Their cost of borrowing is getting higher as more and more people who invest in shares are more and more uncomfortable that the companies are going to continue to face these huge losses.

Investors are savvy individuals. All of which, I say, spells trouble.

Q: What are the best and worst case scenarios?

A: It’s unavoidable that government is going to have to step in. They (Fannie and Freddie) are GSEs – government sponsored enterprises – established companies of the federal government with special protection and special privileges.

What should be done — and the first fact that has to be made explicit – is that these companies cannot be allowed to fail. Everyone in the know knows that. That is for very practical reasons.

The failure of just one of them would be catastrophic for economies around the world. Their debt is held by financial institutions over the world. … On a more national level, with the collapse of sub-prime lending, they are even more important to the housing market and the whole economy.

The worst case scenario would be obvious. It all has such a tremendous impact on the global impact that it could plunge the world – and typically I don’t like to throw out incendiary words – into a depression.

Q: How have Fannie and Freddie managed, up until recently, to float above the financial fray?

A: Fannie Mae (and Freddie Mac) are well connected politically. Both employ a lot of talented lobbyists who are able to protect these companies’ interests very well. Part of the reason we are facing these problems is that they have been able to forestall meaningful legislation that might adversely affect their interests. They are no worse in that respect than any other large company. They have played the game very well and managed to insulate themselves from adverse regulation. They have been very successful in playing the political game with both parties.

We can’t blame these companies for what happened with the foreclosure crisis. It’s one of the bigger casualties in this whole debacle.

Q: Did you, as an economist and an academic, see this coming?

A: It’s a house of cards (starting) with the mortgage foreclosure crisis. Once that started to unfold, literally, the victims were hard to predict. I expected something after the situation with Bear Stearns and Lehmann Brothers. Once the expletive hit the fan, it wasn’t long before companies like Fannie and Freddie would be affected.

Q: Who is likely to be most affected?

A: Until the housing market stabilizes, homebuyers, without a doubt, are going to be hit with higher interest rates. As mortgages become more expensive, new borrowers will have to pay double digit – that’s 10 percent or more – in monthly mortgage payments. If you are in the market for a new home, it’s going to be harder to get a mortgage. Lenders will have to charge more. There is a great deal of uncertainty roiling these markets.

Q: What is at the root of the crisis?

A: There are two things going on here, the foreclosure mortgage crisis, which is almost treated as a side story. It’s not the real cause. To some extent, the real cause is what’s been happening in these companies, Fannie and Freddie. Their exposure to the housing market has soared between the late ’90s to present days.

Outstanding guaranteed mortgages increased by an enormous amount. Now the delinquent rate on these mortgages is rising. That increases the likelihood that companies will have to make good on their guarantees.

The cost of borrowing is a volatile situation. Borrowing costs are getting higher. All of this is a reflection of how concerned are the people who invest in these companies.

Q: F and F apparently differ from other mortgage lenders. How?

A: A lot of people have been concerned for a long time how these companies were protected by being GSEs from the real world. … These companies aren’t subject to the same regulations as their competitors even though they sell shares in the stock market. They have something their private competitors don’t have. If they run into trouble, there’s a government guarantee. It was implicit, a wink and a nod.

It goes back to Paul O’Neill (Treasury secretary, 2001-02) who claimed there was no implicit guarantee. But there was. It (a federal guarantee) means taxpayers would cope with the losses. It served to insulate these investors from the kind of turmoil (they’d have) if they were private competitors. There were lots of benefits from their charter. For example, they’re exempt from state and federal taxes. There are no state capital requirements, and there’s their ability to borrow money at discounted rates.

Q: Are there particular ramifications for the people of the St. Louis region?

A: We seem to have gotten away better than, say, Cleveland or California, (but) the foreclosure piece of it is just one aspect. In terms of the effect of what’s happened with Fannie and Freddie, there are no specific repercussions to the area, except for the proportion of home ownership. But because of the hugeness of these companies, it’s going to have an across-the-board effect.

Q: What do you make of the timing of the crisis?

A: It’s unfortunate that all of this is unraveling now. We’re in such a state of uncertainty. We have an urgent need and everyone recognizes it. The president came out with his package. The presumptive (presidential) nominees have come up with theirs.

But this is an election year at the very peak of the election cycle, so there’s a lot of rhetoric and little in terms of specifics. No one is going to want to take drastic action. They will want to wait and see what the other guy says. No one wants to go out and lose an election because of it.

Everyone is going to pass the buck until at least November, then hope.

I think they need to do something done right away. I hope Congress and the president can put aside partisan political reasons and do something for the good of the country.

Both (candidates) have put together a good strategy, but neither has addressed the underlying issue. They have put a Band-Aid on the problem, and that might be all they can do for now. But that’s not going to work in the long run. We need a much more comprehensive package dealing with reforming regulations and a workable set of regulations (to prevent this) from happening in the future. I am skeptical of the president and Congress acting in concert in the last months (of the administration).

Q: Why should the average St. Louisan care about which one’s Freddie and which is Fannie?

A: That’s a question that can go a lot of different ways. This is a transitional period in the economy, nationally in particular, but in the world. I say transitional because it’s a euphemism for a kind of late 1970s depression. I am not suggesting we are going to have the same level of distress we experienced in the ’30s, the Great Depression.

I am suggesting – and there’s a lot to bear this out – that we are undergoing a tremendous transformation in the national economy. The ramifications are yet to be known. Fannie and Freddie are just one aspect of it.

Q: In the Fannie and Freddie saga, do you see any correlation with the InBev takeover of Anheuser-Busch?

A: It’s important for us as a region to try to figure out how to use this period, to derive benefits both individually and as a region. A part of what happened (A-B bought by InBev) is that we were behind the curve. A-B, whether because of its complacency or poor corporate leadership, did not think it needed (to be more global).

Q: Ultimately, are you optimistic or pessimistic that the U.S. is going to learn from or benefit from this Mae and Mac dilemma?

A: In any transformation era, there will be opportunities, people able to take advantage. But if we look at it pessimistically – the sky is falling – nothing good will come out of this.

I am a little more optimistic about certain businesses. I am not optimistic about automakers or greatly optimistic about our political system coping with the situation.

But I think I am more optimistic about other segments of the economy. Maybe this will force the political system to reform itself to be allowed to be in a better position to cope with crises of the future.

Q: Any closing thoughts?

A: There is an old Chinese saying that has to do with a crisis being part danger and part opportunity.

Robert Cropf, Ladue, holds a doctorate in public policy from New York University. A native upstate New Yorker, he’s been at SLU since 1991.

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