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The big political news occurring this past weekend had little to do with either campaign as they come out of their respective conventions in an essentially dead heat. For while the media and blogosphere remained obsessed with discovering whether GOP vice presidential hopeful Gov. Sarah Palin might have at one time stepped on an ant some of us were looking instead at the opening provided to Sen. John McCain by the announcement late Friday that the US government was putting the two giant GSE (Government Sponsored Entity) secondary home mortgage giants Fannie Mae and Freddie Mac into conservatorship in order to bolster their capital position, keep them solvent and prevent further erosion of the already volatile global credit markets. This move by Treasury Secretary Hank Paulson and the Bush administration will feature regular infusions of taxpayer cash into both entities and the dismissal of both the senior management and boards of both companies in what amounts to a Chapter 11 bankruptcy proceeding.
As most readers are probably aware, Fannie Mae got its start during the New Deal as a government-owned creature designed to buy home mortgages from the lender at point of origin in order to free up these banks and savings institutions to make new loans to other borrowers. In the late 1960s, Fannie (Federal National Mortgage Association) was turned into a private company which still gained favorable credit terms by its continuing loose association with the federal government. Freddie Mac (Federal Home Mortgage Loan Corporation) was created at the same time in the late '60s along the same lines as a smaller version of Fannie Mae. Neither entity is subject to federal or state income taxation and both have long maintained "foundations" whose main aim is to spread cash among favored politicos in Washington. Together these two companies amount to about 70% or so of the total secondary market for home mortgages in which mortgages are bought from the originating lenders and then packaged into tranches which are sold to investors in what is known as a Collateralized Debt Obligation (CDO).
While critics have long complained that the favorable association with the government gives these two an unfair competitive advantage vis-a-vis their straight private rivals and represents a classic example of institutions putting taxpayer dollars at risk by being "too big to fail" the system worked well enough for a long time to make home mortgages more available to borrowers by freeing up the capital needed from the local lender to make more loans. Both institutions were also known for their adherence to a strict "golden rule" (those with the gold make the rules) underwriting policy which in the old days demanded down payments of 20% to avoid private mortgage insurance for borrowers and income/debt ratios that stated borrowers could only have 33% of their monthly gross income going to their mortgage payment and no more than 26% of their monthly income otherwise devoted to installment debt.
But then in the early to mid 1990s things began to change. Point of origin banks had long been targeted by special interest groups for alleged "red-lining" of loans to poor and minority borrowers in which they either avoided some areas altogether or charged allegedly exorbitant interest rates to less credit worthy borrowers. This resulted in the Community Reinvestment Act of 1977 which was supposed to force banks to devote a certain percentage of their lending to underserved or excluded communities and borrowers. Enforcement, however, was lax. So in the early 1990s the Clinton administration and HUD Secretary Henry Cisneros announced The National Homeownership Strategy: Partners in the American Dream:
. . .It promoted paper-thin downpayments and pushed for ways to get lenders to give mortgage loans to first-time buyers with shaky financing and incomes. It's clear now that the erosion of lending standards pushed prices up by increasing demand, and later led to waves of defaults by people who never should have bought a home in the first place.
President Bush continued the practices because they dovetailed with his Ownership Society goals, and of course Congress was strongly behind the push. But Clinton and his administration must shoulder some of the blame.
The old underwriting standards at Fannie and Freddie flew out the window in a wave of exotic home mortgages like "interest-only" loans that teased in borrowers to buy more house than they could afford by offering lower initial payments which would reset to possibly higher payments later. Combined with low interest rates promulgated by the Federal Reserve under Chairman Alan Greenspan, ever rising home values in many densely populated markets like southern California and south Florida, speculators who were buying up houses hoping to flip them in short order for profits of as much as 25% in a year and the stage was set for the perfect financial storm as banks, Wall Street and foreign financial markets loaded up with these CDOs. Everyone was making tons of money so who was to worry? Well, some of us with long experience in real estate were but our voices were not heeded.
So in 2007 as inflation rose on the back of increased energy costs and the initial teaser rates for borrowers were set to reset at higher rates requiring higher payments the bubble began deflating with a vengeance. Borrowers already maxed out with debt saw falling property values leave them no hope to refinance their suddenly more expensive mortgages as they had no equity and then the wave of foreclosures began and financial institutions suddenly found that what they assumed to be the golden geese turned out to be pigs in a poke. Many had purchased these securities on credit themselves with little actual cash capital required and some like Bear Stearns found themselves technically insolvent virtually overnight.
So what's the political angle in this for McCain you might ask? Well, Fannie Mae has long been the sinecure where Democratic Party functionaries have gone to get rich. The most well-known figures are former chairman Jim Johnson (once the head of Barack Obama's vice presidential search committee before being replaced by Caroline Kennedy), 9/11 Commission member and former deputy attorney general Jamie Gorelick who served as Fannie Mae's vice chairman from 1997 to 2003. But the most notorious former Democratic apparatchik in this respect is former Clinton OMB director Frank Raines. Under his leadership Fannie Mae was accused of cooking its books to boost the multi-million dollar bonuses paid to its top executives and Raines settled with regulators for the astonishing sum of $24.7 million. But the story doesn't end there as we found out this last spring with the sweetheart loan deals offered to Democratic Senators Kent Conrad and Christopher Dodd by former Countrywide Home Loan chief Angelo Mozila in what was aptly title the "friends of Angelo" program.
This close Democratic connection puts Barack Obama into somewhat of an awkward position in that in order for him to match McCain's call for the breakup and privatization of Fannie and Freddie he's going to have to go against some of the most senior members of his own party in order to prove that he too is about standing up to these entrenched special interests. And if it's one thing we know about Barack Obama it is that he has never taken such positions in his life.
