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Fannie Mae and Freddie Mac - A Political Scandal?

Fannie Mae and Freddie Mac - A Political Scandal?

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An essay for the 2011 Undergraduate Awards (Ireland) Competition by Victoria Ramsey. Originally submitted for BSc Geography at Queen University Belfast, with lecturer Niall Majury in the category of Business
An essay for the 2011 Undergraduate Awards (Ireland) Competition by Victoria Ramsey. Originally submitted for BSc Geography at Queen University Belfast, with lecturer Niall Majury in the category of Business

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Published by: Undergraduate Awards on Aug 31, 2012
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10/27/2013

 
Fannie Mae and Freddie Mac
 – 
A Political Scandal?
 
Introduction to the Scandal
Fannie Mae and Freddie Mac were the two largest financial institutions on the planet,responsible for financing 80% of all new mortgages in the US. It is therefore no surprise thatwhen the US housing bubble burst in 2007 and their
subprime “junk loans” surfaced
, theyhad the potential to trigger a collapse in the global financial system (Wallison and Calomiris,2009, p76; Wood, 2009). The role of The Federal National Mortgage Association (FannieMae) and The Federal Home Loan Mortgage Corporation (Freddie Mac) is to buy mortgagesfrom mortgage providers and sell them as securities to afford banks and building societiesmore scope to lend to borrowers (Thompson, 2009). Privatised in 1968 Fannie Mae and later
Freddie Mac became “share
-
holder owned companies with a public mission” causing a
conflict of interest (Wallison and Calomiris, 2009, p72). Their government mission was tokeep mortgage interest rates low and increase support for affordable housing, while theirprivate mission was to fight increases in regulation that would raise costs, and reduce risk taking and profitability (Wallison and Calomiris, 2009).
After Fannie and Freddie’s
accounting scandals of 2003 and 2004, questions were raised about their activities of holdingportfolios of mortgages and mortgage backed securities exposing tax payers and the widereconomy to significant risks. In addition, it was argued that their activities did not have muchof a role to play in reducing mortgage interest rates (Wallison and Calomiris, 2009). Fearingthat these government sponsored enterprises
(GSE’s)
would lose political support, they madean agreement with Congress to increase their efforts on their affordable housing mission. In2004 the Department of Housing and Urban Development (HUD) requested that Fannie andFreddie significantly increase their amount of subprime and Alt-A mortgage loans. As a
result between 2004 and 2007, the two GSE’s were the largest buyers of these mortgage
-backed securities (MBS) but the HUD failed to state that the loans had to conform to goodlending practices (Wallison and Calomiris, 2009; Thompson, 2009). People with poor credithistories were lured into these loans by attractive low interest rates that would reset aftertwo/three years to a substantially higher percentage.Once Fannie and Freddie acquired these loans they were packaged together and divided intotranches, known as
collateralised debt obligations (CDO’s)
, of varying rates of risk and soldon financial markets as securities.
These CDO’s
were held by hedge funds, pension fundsand governments around the world. Between 2004 and 2006, the Fed increased interest ratesby 4 percentage points, resulting in mortgage interest rates to climb on subprime loans.When the housing bubble burst and the teaser period interest rates reset many people couldnot afford their mortgage payments. In 2006, there was a steep increase in the number of defaults on subprime mortgages and foreclosures causing a number of subprime mortgagelenders to collapse (Financial Times, 2008a). By 2007, the delinquency rate on subprimemortgages in the US rose to 17% (Panitch and Konings, 2009). A wave of uncertaintyflowed through the financial markets causing the value of mortgage-backed securities toplummet and the seizing up of money markets (Langley, 2008). By August 2008 Fannie Maeand Freddie Mac had a combined unpaid principal balance exposures of $1.011trillion onsubprime junk loans (Wallison and Calomiris, 2009). In order to soften the blow OFHEO
 
allowed both the GSE’s to reduce their capital requirements
from 20% to 15% and inject$200billion of finance into the mortgage market in 2008. Despite this, shares in the twocompanies began to plummet to their lowest levels since 1991 (Financial Times, 2008a;2008b). Finally in September 2008, the Treasury Secretary, Henry Paulson announced that
Fannie Mae and Freddie Mac posed a “systematic risk”
to the entire financial system andwould be taken into conservatorship by the US government resulting in a multi-billion dollarbailout with tax payers money (Wood, 2009).Fannie and Freddie were responsible for the weakening and destruction of many financialinstitutions and investors in the US and further afield (Wallison and Calomiris, 2009). In theaftermath of a global credit crunch questions are being raised regarding how these two
institutions were allowed and encouraged to engage in this “risky subprime mortgage binge”
(Wallison and Calomiris, 2009, p71). Blame has been passed around from the twocompanies themselves, to the mortgage lenders, the credit rating companies, former FederalReserve Chairman Alan Greenspan and the regulators. However, as Gordon Clark points out
that instead of passing the blame around it is important to “appreciate the signifi
cance of theculture of finance which provide the logic by which so many people in the industry actually
 behave” (1997, p222).
The media has become obsessed with demonising individuals orgroups of people when it comes to financial scandals, failing to assign liability with theinternal structures of incentives, the scope of authority and the status of relationships withinthe finance industry (Clark, 1997). This essay addresses the culture of finance surroundingFannie Mae and Freddie Mac
 – 
the structure of the subprime mortgage market, the
companies’
relationships with Congress and the wider political economy, and the systems of regulation in place.
Structure of the Subprime Mortgage Market
 The subprime mortgage market was formed in response to new credit scoring techniques inthe prime market excluding 20% of potential borrowers. Only those with a Fair IsaacCorporation score above 660 are accepted by the prime market. Credit scoring techniques arebased on a linear pattern of assumptions that people will have a continuously improvingemployment and credit career, unfortunately not the case for everyone. This left a gap in themarket between the illegal money lenders and the prime market, which could be exploited bymodern credit rating techniques and securitisation making it very profitable (Burton et al,2004; Langley, 2008; Wallison and Calomiris, 2009). Lending companies and banksestablished lending practices based on risk-based pricing. The likelihood of a customerdefaulting is calculated, then borrowers are categorised and charged graduated rates of interest based on their risk of default, ensuring banks make a profit despite the level of risk (Langley, 2008). However, there seemed to be a lack of transparency in the mortgageagreements. People were lured in by low interest teaser rates that would reset after two orthree years to much higher rates. Some of these mortgages took the form of adjustable-rate
mortgages (ARM’s).
Interest rates would vary according to changes in lending rates and theywere often interest-only mortgages without amortisation and based on the assumption thathouse prices would continue to rise creating equity for the owner to meet future payments(Langley, 2008; Ferguson, 2009). Many people did not come from a financial background
 
and did not question the details of the loan, happy to be getting any type of loan under theircircumstances (Bolderson, 2009).The credit rating companies have come under significant scrutiny for underwriting loansdeemed too risky. The nature of incentives in these companies and their relationships withthe subprime mortgage lenders and investment banks put them in a compromising position.When interviewing a mortgage underwriter Bolderson (2009) found that out of all theapplications she received, only 30% would have been considered as having good prospectsfor a loan. However, lenders wanted to sign up the remaining 70% as it was not their moneythey were lending but that of investment banks in Wall Street. Underwriters were put underpressure to approve just about anyone for a loan and when they were reluctant to underwrite
the loan they were showered with “bribes” in the form of expensive watches, cars, trips etc
(Bolderson, 2009). These credit scoring agencies were funded by their clientele of banks andother lending companies and it was in their interest if they wanted to continue doing businesswith these companies that they would look upon applications favourably.Once the loans were granted the securitisation process began as mentioned previously turning
MBS into CDO’s and shipped off all around the globe.
By the end of 2006 three quarters of all US mortgages were securitised (Langley, 2008). Relationships between rating agenciesand investment banks were similar to that above between the former and lending companies.The dependant relationships constructed in the subprime industry resulted in accountingpractices that concealed the potentially high risks
of securities. For example, some CDO’s
rated as AAA representing low risk and highly liquid instruments disguised the actual risk these securities posed to investors (Langley, 2008). Given the global nature of MBS marketFerguson describes it as one where
“no one can hear you scream” because mortgage
payments are going to someone that does not even know the borrower exists (2009, p262).The complexity of the sub-prime mortgage market resulted in a domino effect circulating theglobe as defaults triggered more defaults along the chain. The exact location of these baddebts was difficult to track in the financial system causing capital flows to completely seizeup when the credit bubble burst in 2006.On top of these dependant relationships there were problems underlying the systems of creditscoring. The relative infancy of the market itself, meant that there was a lack of historicaldata on which to base calculations of the probability of default by borrowers. Data whichwas only available for the last decade or so was embedded in a time with low and stableinterest rates and rising house prices. Risk-
 based pricing only focuses on a borrower’s credit
history and disregards the influence of wider economic conditions leaving portfolios open tolarge risks (Langley, 2008).Regulation of credit scoring in the US falls
under the controversial concept of “red
-
lining”,
when an entire area is given a negative credit rating. Historically this happened inpredominantly black areas (Ferguson, 2009). Campaigns for Civil Rights in the 1960s causedred-lining to be outlawed by the Equal Credit Opportunities Act of 1976. Discrimination onthe grounds of race would no longer be tolerated in the financial markets. Despite thislegislation it is usually minority groups who fall into the subprime categories and pay higher

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