By: Mendel Harlig  | 

The Case Everyone Should Be Following

Do you believe that the government should stay out of the financial sector? Or, do you maintain that government has the ability to meddle with affairs if it’s for the public good, and perhaps should even control more of the private markets? Whatever your perspective is on the role of government, one should be fascinated with the current court cases that are taking place between the government and members of the private sector regarding Freddie Mac and Fannie Mae. When people purchase a house, they often rely on a mortgage due to a lack of funds. The bank that originates the mortgage usually does not retain the mortgage. Most of the mortgages that the banks initiate are bought by one of the government-sponsored enterprises (GSEs), Freddie Mac, Fannie Mae, or Ginnie Mae. This provides the banks with the necessary capital to lend further. Additionally, the banks don’t have to be exposed to the risk of homeowners possibly defaulting on the loan because the GSEs own it. The GSEs securitize the loan as a mortgage backed security (MBS), where if the borrower defaults on the loan, the GSEs will incur the financial burden, and they sell it as an MBS on the secondary mortgage market as a bond at a premium.

The history of the GSEs begins in 1938 with the establishment of Fannie Mae by the federal government in order to make homeownership more affordable and increase the percentage of homeowners,[i] by giving money to finance mortgages.[ii] In 1954, Fannie Mae became a mixed ownership corporation with the federal government maintaining its preferred stock and the private sector owning the common stock.[iii] In 1968, Fannie Mae was broken up into two corporations: Ginnie Mae and Fannie Mae.[iv] Ginnie Mae is owned by the federal government and thus has the explicit backing of the federal government in form of a guarantee that the federal government will pay if borrowers default on their loan[v]. Fannie Mae was completely released into the private sector. Fannie Mae always had the implicit backing of the government because the government would burden it to increase its loan portfolio to mortgages programs that are created by the federal government – usually for people who wouldn’t meet the standards of acquiring a mortgage from a regular bank. In 1970, Freddie Mac was created in order to compete with Fannie Mae in the secondary mortgage market.[vi]

In 1992, President George Bush signed the housing development act which required that GSEs, including Freddie Mac, Fannie Mae, and Ginnie Mae, help low and average income people attain a mortgage by ensuring the financing of affordable housing loans that are regulated by the Department of Housing and Urban Development (HUD).[vii] The HUD allows a low down payment, and lessens the monthly payment of the loan by regulating the interest rate and increasing the time of the loan to thirty years.[viii] Therefore, if there were a homeowner that couldn’t attain a ten-year mortgage because his loan to income ratio—how much the monthly payment is relative to the person’s monthly income—was too high, in many instances he would have an acceptable loan to income ratio over a thirty-year mortgage.

In 1999, the Clinton Administration encouraged Fannie Mae to increase its mortgages to people of low and average income by increasing lending in distressed cities. Additionally, banks pressured Fannie Mae to issue mortgages at lower credit requirements and higher interest—also known as subprime mortgages—in order to increase the number of loans the banks can distribute.[ix] Private lenders would issue risky loans because they knew that Freddie Mac and Fannie Mae would bear the majority of the responsibility if they don’t pay.[x] As subprime mortgages increased, many lenders defaulted on their loans causing housing prices to go down. Freddie Mac and Fannie Mae owned five trillion dollars of debt and guaranteed half the loans in the mortgage market. It was rumored that Fannie Mae would go bankrupt which would cause a global financial crisis because their bonds were owned by many citizens in the United States and countries throughout the world.[xi] The government decided to give 187.5 billion dollars of taxpayer money to bail out Freddie Mac and Fannie Mae, and put them in conservatorship—the government would maintain control of them for a period of time. The government assumed control of nearly eighty percent of the stock and gave itself a special preferred stock that made Freddie Mac and Fannie Mae pay 10 percent interest on the bailout money they received.[xii] All dividends from the preferred stock and common stock that were owned by private shareholders were suspended.

In 2012, Freddie Mac and Fannie Mae became profitable again, together making 8 billion profit in the second quarter.[xiii] However, instead of accepting 10 percent of this profit as an interest payment, and distributing the rest of the profit as a dividend to stockholders, the government conducted a federal takeover of all the profits of Freddie Mac and Fannie, claiming that it changed the terms in order to wind down Freddie Mac and Fannie Mae so it wouldn’t have to burden taxpayers in the future if another crisis occurs.

Private stockholders decided to sue the federal government for violating the fifth amendment: “nor shall private property be taken without just compensation.” The plaintiffs argue that in 2008, Freddie Mac and Fannie Mae were put in conservatorship, which gave the government control of the companies for a temporary period of time after which they’d be released back into the private sector. Yet, in the case of Freddie Mac and Fannie Mae the government has not released them back into the private sector but in effect has done the opposite—they’ve taken ownership of the companies. Therefore, stockholders that own a share of the company will never receive dividends, neither from the profits they earned in 2012 nor from future profits. Additionally, since the government claims that it wants to eventually shut-down down the companies, the stocks will essentially be worth nothing at some point. All the investors that bought up Freddie Mac and Fannie Mae at a discount—when its stock was low and it was getting bailed out by the government—with the belief that the companies would eventually become profitable causing the stock’s value to go up exponentially, have been snubbed.

The plaintiffs have won the first step of the battle with Judge Margaret Sweeney ruling the release of government documents regarding the sudden seizure of Freddie Mac’s and Fannie Mae’s profits.[xiv] The government is now attempting to appeal the decision. Some people claim the government's behavior with Freddie Mac and Fannie Mae manifests the corruption of the federal government—namely that the government is keeping all the companies’ profits while not paying dividends to the private owners of twenty percent of the stock that is privately owned, despite the fact that the government has already been compensated for the money they were owed from the bailout. Others maintain that Freddie Mac and Fannie Mae should be terminated because they were one of the many culprits of the financial crisis, and the mortgage market should be conducted in the private market. Regardless, everyone should be following this story as it develops. The outcome of this case will establish vast legal precedent for whether the government can confiscate private property with impunity.

[i] 2006 Annual Report" (PDF). Retrieved 2015-03-11

[ii] Alford, Rob. "History News Network | What Are the Origins of Freddie Mac and Fannie Mae?". Retrieved 2015-03-11.

[iii]  "2006 Annual Report" (PDF). Retrieved 2015-03-11.

[iv]  Krishna Guha, Saskia Scholtes, James Politi: Saviours of the suburbs, Financial Times, June 4, 2008, page 13

[v]  Fabozzi, Frank J.; Modigliani, Franco (1992), Mortgage and Mortgage-backed Securities Markets, Harvard Business School Press, p. 20, ISBN 0-87584-322-0

[vi] Fabozzi, Frank J.; Modigliani, Franco (1992), Mortgage and Mortgage-backed Securities Markets, Harvard Business School Press, p. 20, ISBN 0-87584-322-0

[vii]  "12 U.S. Code § 4501 - Congressional findings | LII / Legal Information Institute". Retrieved 2015-03-11.

[viii]  HUD 2002 Annual Housing Activities Report

[ix]  Holmes, Steven A. (September 30, 1999). "Fannie Mae Eases Credit To Aid Mortgage Lending". New York Times

[x] "Competition and Crisis in Mortgage Securitization by Michael Simkovic". SSRN. doi:10.2139/ssrn.1924831. Retrieved 2015-03-11.

[xi]  On the Brink, Henry Paulson