Tuesday, October 7, 2008

What Went Wrong with Fannie

Competition from other market players, pressure from Congress and other causes of Fannie Mae going off the tracks are well chronicled in this New York Times story. If you're looking for one thing to read to understand what Fannie Mae is and what happened to bring it down, necessitating a federal government takeover, this is a great place to start.

What Is Fannie Mae?

Fannie Mae (an acronym for Federal National Mortgage Association) is a private company that began life as a New Deal federal government agency but was privatized in the 1960s by President Johnson, who wanted to move its debt off the federal government's books. Its role was (is) to purchase mortgages from lenders, bundle them into investment securities and sell them into the market. This allowed the home lenders to take the loans off their books and make new ones. Fannie Mae also guaranteed those securities. Because it had special status under federal law, lenders were willing to lend to Fannie at lower rates, believing that the federal government would stand by should Fannie ever go belly up - a belief that turned out to be true.

What Went Wrong?

As the home loan market grew, more and more actors in the financial community were willing to take on this role. This forced Fannie to take bigger risks. At the same time, Fannie was faced with increasing pressure from Capitol Hill, which began to worry that its activities might lead to either problems in the market, cost taxpayers large sums of money if it needed to be bailed out, or both. To ward off more oversight and regulation, it sucumbed to legislators' demands that it increase the amount of lending it did to lower income groups, which are by nature riskier. The increased risks it took to compete in the hot housing markets and placate federal law makers (and regulators) put it in a precarious position. After years of tremendous growth (any payments to its top executives), federal regulators discovered accounting fraud at Fannie in 2004. In recent years, as many of the loans Fannie bundled and resold go into default, its had to make good on its guarantees, leading to staggering losses.

About one year ago, Congress and federal regulators, knowing Fannie's state, pressured them to buy up a lot of bad subprime loans - in other words to act in much the way the US Treasury proposes to do under the bailout. Despite being a supposedly private entity, Fannie sucumbed and did so, making its balance sheet even worse.

Why is All This Important to the Current Situation?

By packaging these bad loans, Fannie helped take what should have been a crisis in one market - housing finance - and distributed all over the world as investors purchased them. Precisely how much of the fault should be placed on those who operated Fannie and those who pressured it into riskier and riskier activity remains the subject of much debate.

Anyway, the article is well written, in plain English and worth the time it takes to read.

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