In the crisis that engulfed the global financial system in 2008, the collapse of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) inflicted the heaviest losses of all on U.S. taxpayers. The Congressional Budget Office has estimated that the cost of bailing out the government-sponsored enterprises (GSEs) could ultimately total $350 billion. Unlike the banks that received massive government loans, guarantees, and insurance, Fannie Mae and Freddie Mac have little prospect of ever repaying Uncle Sam. Notwithstanding this stark evidence of fundamental flaws in the structure and mission of the GSEs, the sweeping legislative response to the financial crisis—the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010—dealt with the GSEs only by calling for a study of how they could be reformed.
New York University professors Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White lay out a plan for averting a repeat of the disaster. In Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, they recognize that the first step is to understand what went wrong. That understanding depends on clearing away several misconceptions about the housing debacle.
One politically charged claim is that Fannie Mae and Freddie Mac increased the riskiness of their loan portfolios beginning in 2004 because of congressionally imposed targets for increased homeownership. Although the authors acknowledge that such meddling was unhelpful, they point out that the GSEs missed some of the homeownership targets without incurring material penalties. They argue that the primary impetus for the increased risk taking was intensified competition from private-label securitization by other financial institutions. In pursuit of private profits, Fannie Mae and Freddie Mac adopted more aggressive strategies, knowing that any resulting losses would be socialized.
Acharya, Richardson, Van Nieuwerburgh, and White also reject the GSEs’ attempts to blame their failure on an extraordinary drop in housing prices. Although the decline in housing prices was unquestionably steep, Fannie Mae and Freddie Mac would have failed even in a milder downturn, say the authors. The GSEs had overborrowed massively, an unsurprising consequence of a game designed to persuade buyers of GSE debt that the government would stand behind the debt without having to put the associated liabilities on its balance sheet.
Another myth about the housing debacle is that it was unforeseeable, which might absolve politicians and GSE executives of blame for taxpayers’ losses. In October 1999, U.S. Treasury Secretary Lawrence Summers said that the GSEs should be included in debates about systemic risk. Fed Chairman Ben Bernanke echoed those remarks in March 2007. In June 2005, the Economist described the worldwide rise in housing prices as the biggest bubble of all time.
A final fallacy pointed out by the authors is that the costs of the GSE bailout were somehow justified by the high homeownership rates that were supposedly achieved through government support of Fannie Mae and Freddie Mac. In reality, although the United States intervenes much more extensively than any other national government to promote homeownership, homeownership rates are higher in many other countries, ranging from Singapore and Spain to the United Kingdom and Canada. When the bust came, it hit harder in the United States than anywhere else. No other country suffered a nearly complete collapse of private-sector mortgage lending and securitization as the United States did in the “nonconforming” segment (i.e., loans that do not meet certain GSE guidelines).
Guaranteed to Fail completely dismantles the official version of Fannie and Freddie’s contribution to the housing market. The GSEs’ rationale for holding some mortgages in their portfolios, rather than acting exclusively as guarantors, was to promote liquidity in the secondary mortgage market. But the authors find no evidence of a direct link between the GSEs’ portfolios and liquidity. Reducing their subsidies, warned Fannie Mae and Freddie Mac, would raise mortgage rates and, therefore, lower housing prices. The authors, however, report that recent research finds a weaker link between mortgage rates and housing prices than previously believed.
No one can accuse the authors of failing to offer solutions to the problems they so thoroughly document. Their specific recommendations include eliminating the GSEs’ investment function and restricting GSE guarantees to conforming mortgages. They also advocate reducing the government’s homeownership objectives and tasking the U.S. Department of Housing and Urban Development with setting them rather than entangling them with the GSEs’ objective of fostering a healthy secondary market for mortgage securitization.
Acharya, Richardson, Van Nieuwerburgh, and White present their policy prescriptions in the context of alternatives that they also deem reasonable. This approach is consistent with the book’s uniformly objective and civil tone, notwithstanding the politically explosive issues with which it deals. One can only hope that some trace of the constructive approach of Guaranteed to Fail will inform the ongoing debate in Washington on the vitally important question of the future structure of the U.S. mortgage market.
—M.S.F.