Just who (or what) was Freddie Mac? Why did our “murky government ties” matter so much?
In the early 1990s, I helped staff a meeting between our top economists and some visiting officials from Mexico. After a hearty lunch, one of our visitors wiped his moustache and put down his linen napkin. Turning to a Freddie economist, he asked, “So, I am still having trouble understanding what you are saying. Is Freddie Mac part of the United States government or not?”
It was a delicate moment and I wondered who would answer the question. But the economists were nonplussed. “No, we are not part of the U.S. government,” said one firmly. “Rather, we’re government-sponsored…”
Our guests nodded politely, but continued to press. They had heard of Ginnie Mae, the government corporation that securitizes mortgages insured by FHA and VA, both of which are government agencies. What about the GSEs? How were they different?
The discussion went long into the afternoon. Our visitors were impressed with data showing the size and scope of the U.S. housing market, homeownership rate, and the tight spread between the rates on Freddie-guaranteed mortgage-backed securities and U.S. Treasuries. They just couldn’t quite grasp how it all worked.
How could Freddie Mac raise funds so cheaply for housing if it was not part of the government?
Family Jewels: The GSE Charter
On paper, the benefits of the GSE charter might seem disproportionate to the prodigious wealth they brought GSE shareholders. However, the value of the GSE charter was not located in the explicit privileges themselves—although they were beneficial—but rather in what the privileges, taken together, signified about the ambiguous relationship of the GSEs with the U.S. government.
Despite company protestations to the contrary, that ambiguity made the GSEs appear safer than they really were.
[Because of the charter] Freddie and Fannie mortgages securities were rated “triple A” by the credit rating agencies–the same rating that an investor would see on a Ginnie Mae security, or, for that matter, a Treasury security. There was only one difference: Treasuries and Ginnies truly carried the full faith and credit guarantee of the U.S. government.
The GSE AAA rating had no such explicit guarantee.
Rather, the GSE AAA rating belied a so-called implicit guarantee—an artifact derived from the urban legend that the government would stand behind the institutions if one or the other ever got into trouble. The implicit guarantee arose from the unusual quasi-governmental nature of the GSEs. It prevailed even though every member of Congress, the GSE regulator and every GSE securities’ offering said otherwise.
Shrewd investors remained unconvinced. They believed the government would never let the GSEs fall. And, ultimately, they were right.
An Unfortunate Collusion
Looking back on the decade of heated debates over the implicit guarantee, it is clear that the moral hazard contained in the GSE charter was a recipe for disaster. The highly combustible combination of ambiguity about the government’s role, investor shrewdness and the GSE’s own corporate opportunism created a fatal flaw at the core of the U.S. housing finance system.
As history would show, the GSEs took on risks disproportionate to their capital level while muscling around their admittedly weak regulator. Not surprisingly, when the bust came, the risks (and losses) flowed to the government.
To taxpayers.
Excerpted from Chapter 4, Charter Confusion, Days of Slaughter: Inside the Fall of Freddie Mac and Why It Could Happen Again