The Truth About Fannie and Freddie's Role in the Housing Crisis

Separating economic myth from economic fact


Editor's Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: The government-sponsored housing finance companies Fannie Mae and Freddie Mac had nothing to do with the housing crisis. They were simply innocent bystanders caught in the crossfire. Economist and New York Times columnist Paul Krugman, for instance, has argued that Fannie and Freddie's role in the housing market was insignificant between 2004 and 2006 because "they pulled back sharply after 2003, just when housing really got crazy." According to Krugman, Fannie and Freddie "largely faded from the scene during the height of the housing bubble."

Fact 1: Fannie and Freddie contributed to the housing crisis by making it easier for more people to take out loans for houses they could not afford. Beginning in 2000, Fannie and Freddie took on loans with low FICO scores, loans with low down payments, and loans with little or no documentation.

The federal government's role in the housing market goes back at least to 1938, but that role changed fundamentally in the 1990s when the government made a push to increase homeownership in the United States. At that time, the federal government pursued several policies that were meant to encourage banks to lend money to lower income earners and to give incentives to low income earners to buy houses. The result, as we now know, was a gigantic amount of subprime mortgages at a time when house prices were starting to go down.

In 2010, Edward Pinto, a resident fellow at the American Enterprise Institute who has served as chief credit officer at Fannie Mae, issued a memorandum on the number of subprime and other high-risk mortgages in the financial system immediately before the financial crisis. In that memorandum, Pinto recorded that he had found over 25 million subprime mortgages (his later work showed that there were approximately 27 million). Since there are about 55 million total mortgages in the United States, it means that as the financial crisis began, half of all U.S. mortgages were of inferior quality and liable to default when housing prices stopped rising, as you can see in the chart below.

Freddie and Fannie were active players in this market. 

For instance, as George Mason University economist Russ Roberts explains in his paper "Gambling with Other People's Money":

Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS [mortgage-backed securities] sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, MD-based publisher that covers the home loan industry.

In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.

In addition, lawmakers in both parties enacted policies directed at increasing home ownership rates, resulting in lower mortgage underwriting standards for Fannie and Freddie. Roberts notes that from 2000 on, Fannie and Freddie bought loans with low FICO scores, loans with very low down payments, and loans with little or no documentation. Contrary to Paul Krugman's assertions, Fannie and Freddie did not "fade away" or "pull back sharply" between 2004 and 2006.

As the following chart from Roberts' study shows, during that same time Government Sponsored Enterprises (GSEs) bought near-record numbers of mortgages, including an ever-growing number of mortgages with low down payments.

Moreover, as the chart below shows, while private players bought many more subprime loans than Freddie and Fannie, GSEs purchased hundreds of billions of dollars worth of subprime mortgage-backed securities (MBS) from private issuers, holding these securities as investments.

The bottom line is that while Fannie and Freddie weren't the only factor leading to the financial crisis, they played an important role in pushing up the demand for housing at the low end of the market, especially between 1998 and 2003. That in turn made subprime loans increasingly attractive to other financial institutions as housing prices rose steadily.

Myth 2: Fannie and Freddie's role in the housing market increased homeownership, especially for first-time buyers and lower income earners.  

Fact 2: The small increase in homeownership rates were temporary and artificial, driven by unsustainable incentives. In the best case scenario, Fannie and Freddie may have increased the homeownership rate from 63 percent to 69 percent, but the rate has now fallen back to 66 percent. Moreover, Fannie and Freddie did not make housing more affordable and even priced many first-time buyers out of the market.

When it was created in 1938 Fannie Mae's mission was to stabilize the Great Depression's battered home mortgage market by focusing on first-time homebuyers.

From 1940 to 1965, homeownership expanded from 44 to 63 percent. It's debatable whether this increase in homeownership was good, bad, or even if it was the product of Fannie's actions at all.  

However, it is interesting to observe the role that government support has played in Fannie and Freddie's actions. While Fannie and Freddie enjoy access to capital from the public equity market, they also benefit from exclusive privileges including a line of credit with the government, no oversight by the Securities and Exchange Commission, and a government guarantee that gives these entities a lower cost of funds than their private sector rivals.

As business journalist Bill Bonner explains in The Christian Science Monitor:

Armed with these advantages, GSEs increased their book of business from $13 billion in 1965 to $1 trillion by 1990 and $3.4 trillion in 2003. Once the great real estate bubble had concluded by year-end 2007, Freddie and Fannie combined had purchased $4.9 trillion of mortgages, repackaging 70 percent of these into guaranteed securities for the secondary market.

This (along with Ginnie Mae) gave the GSEs roughly half of the $11 trillion mortgage market, but their share of new originations has become near dominant.

Many sources peg this at 70 percent, but an interesting take from TIME magazine business and economics columnist Justin Fox takes into account the impact of refinancing into GSE-backed loans. Juxtaposing GSE total volume ($ 539 billion) against new originations ($313 billion), GSE market share was 172 percent for the first quarter of 2008.

As the chart below shows, while homeownership topped out at 69 percent in 2004 and stood at 66 percent in 2010, it hasn't really increased from its 63 percent level nearly 50 years ago when the government restructured the agencies to promote their growth.

Unfortunately, we also know that many of the government's policies ended up increasing housing prices dramatically by increasing demand, thus pricing many first-time buyers out of the market.

Myth 3: Fannie and Freddie are essential for maintaining a working mortgage market. Without them, interest rates will increase and homeownership will plummet as more people are priced out of the housing market.

Fact 3: Interest rates are likely to go up. Yet it is not clear what impact this will have on homeownership rates. In the 1980s, interest rates on the average 30-year mortgage were significantly higher, yet homeownership rates were almost the same as they are today. Besides, the alternative to homeownership is not living on the street.

President Barack Obama has proposed allowing Fannie and Freddie to slowly fade away. This would certainly have consequences. For one thing, without federal backing, a 30-year mortgage with a 5 percent interest rate is unlikely to be replicated by any bank. In addition to charging higher interest rates, banks would also likely require a larger down payment.

However, it is wrong to assume this will mean a severe decline in homeownership. First, as the following chart shows, in the last 30 years, interest paid by homeowners has fluctuated quite dramatically while the rate of homeownership has remained steady.

In 1981, for example, interest rates were at an all-time high of 16.6 percent and the homeownership rate was 65.4 percent. In 2009, interest rates were at a nearly record low of 5 percent but homeownership held steady at 67.4 percent. The last time we had that homeownership rate was in 2000, and at that point the interest rate was 8 percent.

Furthermore, low down payments are a relatively recent phenomenon. In the 1980s and most of the 1990s, down payments had to be roughly 20 percent of the value of your home.

Finally, higher interest rates and higher down payments are not necessarily a bad thing for homebuyers. Both will incentivize new owners to keep and maintain their new property. If we have learned anything in the last decade, it's that redefining the American dream to mean homeownership for everyone is a very risky endeavor. Besides, the alternative to homeownership is not life on the streets, it is renting.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.