Freddie and Fannie have it both ways

The Financial Page

By James Surowiecki

updated 12:05 p.m. ET July 21, 2008

When do the words “not guaranteed” actually mean “guaranteed”? Whenever the mortgage giants Fannie Mae and Freddie Mac are involved.

The two companies have long been required to tell investors that their securities are not guaranteed by the federal government. But in the financial markets everyone has always assumed that this demurral was just window-dressing, and everyone, it turns out, was right. Last week, when fears of a possible collapse of the two companies threatened to spark a major financial crisis, the Treasury Department and the Federal Reserve quickly came up with a rescue package. What had been an implicit guarantee became an explicit one.

Fannie and Freddie are the duck-billed platypuses of the financial world. They’re profit-driven corporations, owned by shareholders and, in theory, beholden only to them. But they’re also so-called “government-sponsored enterprises,” set up by the state with the explicit mission of fostering homeownership, by buying and selling home mortgages.

Unlike ordinary corporations, they’re exempt from most state and local taxes and certain S.E.C. requirements, and they have access to a government credit line. Other G.S.E.s play similar roles in other markets: the Federal Home Loan Banks make loans to banks, credit unions, and thrifts; the Farm Credit Banks facilitate the flow of credit to farmers; and Farmer Mac buys up farm and rural-housing mortgages. In each case, the government saw a hole in the marketplace and chartered a company to fill it.

The G.S.E.s are curious, because there’s no obvious reason for them to exist in the form they do: Instead of creating private companies to do all these jobs, the government could just do them itself. In fact, that’s how Fannie Mae got started, back in 1938: Originally, it was a government agency endowed with the authority to buy mortgages, in the hope that this would expand the supply of credit to homeowners. It wasn’t until 1968 that Fannie was privatized. (Freddie Mac was created two years later, and was private from the start.)

The main reason for the change was surprisingly mundane: accounting. At the time, Lyndon Johnson was concerned about the effect of the Vietnam War on the federal budget. Making Fannie Mae private moved its liabilities off the government’s books, even if, as the recent crisis made clear, the U.S. was still responsible for those debts. It was a bit like what Enron did thirty years later, when it used “special-purpose entities” to move liabilities off its balance sheet.

Making Fannie and Freddie into these weird hybrids may have spruced up the budget, but in the long run it also made it easy for the companies to grow too big, too fast. Because everyone assumed that the government would make good on Fannie’s and Freddie’s debts, they could borrow money more cheaply than their competitors. They used this cheap debt to increase the number of mortgages they bought. Had Fannie and Freddie been ordinary private companies, there would have been a natural check: Companies with more debt are usually seen as riskier, and that makes shareholders and bondholders less willing to invest in them. Or, had Fannie and Freddie been government agencies, budget constraints would likely have limited the scope of their lending.

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