Days before the collapse of Lehman Brothers, when the crisis was already casting a dark shadow over White House, the US government decided to take over two companies. These two companies were, in some senses, monuments to the US’ phenomenal economic growth in the post-war decades. These were Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) that bought mortgages and created a secondary market in them. These two companies have also become symbols of what went wrong with the US financial system, building up to its worst-ever crash and the subsequent folding up of Lehman Brothers.
New York Times writer Andrew Ross Sorkin’s gripping account of the 2008 financial crisis Too Big To Fail describes the preparations to the government takeover: “As Labor Day weekend approached, the Treasury team and its advisers started to plot the actual details of the dual takeover. They knew they would have to move quickly, with military precision, and in secrecy before the GSEs could start rallying their supporters in Congress… Internally, Treasury officials talked about offering Fannie and Freddie two doors: Door 1, you cooperate; Door 2, we’re doing it anyway.”
Well, that pretty much sums up the nature of the crisis and the involvement of these two companies. GSEs are actually unique because they are a combination of both private enterprise and state backing. These GSEs enjoy a government guarantee that allows them to borrow cheap from the markets; they are also publicly listed and susceptible to pressure from shareholders. This combination allowed them a period of unprecedented growth over the past few decades. But it also gave them unfettered right to build up gigantic debt levels, over-leveraging themselves to the extent of almost contributing to a significant portion of the total national debt.
Given their unique stature, the government’s takeover action was different from the run-of-the-mill acquisitions. The difference came about after the creation of a housing finance regulator in the US — The Federal Housing Finance Agency, described by Wikipedia as an “independent federal agency created as the successor regulatory agency resulting from the statutory merger of the Federal Housing Finance Board (FHFB), the Office of Federal Housing Enterprise Oversight (OFHEO), and the US Department of Housing and Urban Development government-sponsored enterprise mission team, absorbing the powers and regulatory authority of both entities, with expanded legal and regulatory authority, including the ability to place government sponsored enterprises (GSEs) into receivership or conservatorship.”
Therefore, technically, the federal takeover of both Fannie and its smaller cousin Freddie was putting both the GSEs in conservatorship. In other words, this was nothing but the government providing a backstop of $200 billion in additional capital to both companies which were teetering on the brink of bankruptcy. The two entities had combined losses of close to $15 billion. Days before they were admitted into the conservatorship, both had $5 trillion of outstanding mortgage-backed securities and debt, with debt alone accounting for over $1.5 trillion. With the sub-prime crisis spreading fast, the market was worried about the portfolio of these two GSEs and their ability to repay their debts.
At the press conference announcing the putting of these companies into conservatorship, US treasury secretary and former Goldman Sachs chairman Hank Paulson had said: “I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction.” In fact, Washington Post commented that the government action was “one of the most sweeping government interventions in private financial markets in decades.”
The book under review focuses on how the US federal government kept providing guarantees, despite many warnings, and thus aiding the process of the housing finance boom and the eventual collapse. These GSEs were created to provide liquidity to the secondary mortgage markets, backed by government guarantee. But, they ended up over-leveraging themselves, bulking up risks on their books and subsidising wealthier homeowners, with society as a whole bearing the costs ultimately.
The authors – professors at the Leonard N Stern School of Business at New York University -– have laid bare the way a vital component of the US financial system got distorted and how the process was aided by the government for decades. They have, through an epilogue, also drawn parallels with India and the preponderance of GSEs in the economy. GSEs, they feel, eventually end up achieving exactly the opposite of what they are set up to accomplish.
The author is Head, Policy & Research with Dhanlaxmi Bank. Views are personal.
GUARANTEED TO FAIL
Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance
Viral V Acharya, Matthew Richardson, Stijn Van Nieuwerburgh & Lawrence J White
Collins Business; 234 pages; Rs 399