Introduction
This paper critically analyzes the cause of the sub-prime crisis in America by looking at the role of Freddie and Fannie in the housing bubble. This will explain the effects of cheap money, greed and a bad theory for south Florida. Freddie and Fannie are believed to have majorly contributed in the problems of housing speculation and the eventual burst. Mortgage lenders and banks lacked regulation and ethics while the buyers stupidly accepted the risks. Therefore, regarding the economic troubles witnessed in 2008, Fannie Mae and Freddie Mac was the match known to have lit the fire by contributing to wider problem. Although many people may not have heard about these institutions before, Fannie Mae and Freddie Mac are the ones that made all the risky loans and gave them to individuals and other financial institutions that did not afford to pay back. Fannie and Freddie had been set up by the federal government decades ago to manage mortgages and enhance home ownership. Fannie Mae was the federal national mortgage Association and Freddie Mac was the federal home Loan Mortgage corp. Both institutions have been and still are major players in the mortgage market for domestic housing (Coleman, 2008).
Housing bubble
In America, most individuals were deluded into buying houses at a value between $250,000 and $500,000 where they were told that, after about 2-5 years, one would sell them at a higher price. They were also made to believe that, there are only few available homes and failure to buy them now no matter how overpriced they are, prices would continue increasing and would soon be unreachable. As a result, a large number of families spend up to 50% of their income on rent payments or mortgages. However, a physical constraint is being experienced by most of them in their ability to pay consequently causing the same effect of the housing bubble itself. Defaulting aside, some individuals miss paycheck while others loose their jobs. Default rate has also gone up and currently is rated at 10% in some urban areas causing a spread of cumulative mortgage default (Eisenbeis, 2007).
For the last two decades, housing bubble has undergone accelerated growth under the chairman of the Federal Reserve. The housing bubble depends on the large amount of liquidity provided by Fannie Mae and Freddie Mac through secondary real estate markets at home under their control. These two are private corporations and not agencies of the government and are the linchpin of the bubble. Without these two institutions, the housing bubble could not be in existence. Their objective is to inflate the prices of the houses through “fictions value” increment. Size of mortgages required in buying the homes at inflated prices therefore increases. This consequently increases interest rates as well as the principal cash that may be gouged from the households (Eisenbeis, 2007).
Operations of Fannie Mae and Freddie Mac
According to (Eisenbeis, 2007), These two institutions do not make direct loans to homeowners but rather purchase mortgages and translate them into securities, some of which are sold on the open market. Both institutions guaranteed mortgages valued at about $5-trillion and this amounted to half of the U.S market. In 2008 by the summer, deflating housing bubble began having effects on the two institutions where such effects were especially foreclosures as well as mortgage delinquencies. The agencies lacked adequate money in meeting financial obligations they had and this consequently led to the U.S government taking over the obligations on September 7th, 2008. Therefore, Fannie and Freddie are considered to have taken too many loans that were risky and that are what caused the crisis being witnessed today in American market (Coleman, 2008).
Research has shown that, many economists are in agreement that both Fannie and Freddie were major players in the housing bubble but are not in agreement if the two led the way or were just following the pack. Some argue that, when Fannie and Freddie bought this paper on a heavy scale, they targeted to make the market progress through the instruments by encouraging origination’s growth. Other players too contributed to the problem and these included monetary policy that was loose and investment decisions that were not good by other buyers as well as a number of regulatory errors. Some economists claim that, it is absurd to agree on the idea that, Fannies and Freddie were fundamentally the cause of the crisis. The two institutions never acted well in the crisis but rather contributed to it. However, the housing bubble was the primary problem. Fannie and Freddie abruptly joined the subprime market following private mortgage’s issuers that had been backed with securities. They therefore played the role of following and not leading as both sides of the argument indicates. Various other factors made a contribution to the crisis and these included mortgage backed securities which from the appearance, were virtually risk free from the paper. A significant role was played by lax regulation where some agencies never utilized the regulation powers they had or did not utilize them properly. Some of the powers that the Federal Reserve can exercise are to tighten the standards of lending as well as raising the interest rates in the market. However, some officials were not for the new rules and therefore advised the congress on several occasions to stop regulating derivatives.
Unique role played by Fannie and Freddie in the economy
The situation encountered by the two institutions was caused by their role in the economy that was unique. They were majorly set to support the market in the housing plan. As long as the mortgages met certain standards, the two institutions helped guaranteeing them. Fannie and Freddie could fund the guarantees through issuance of debts of their own which the government tacitly backed in turn. This assurance by the government encouraged the two institutions in taking more and more debts beyond a normal company. In principal, Fannie and Freddie were supposed to use the guarantees from the government in reducing the cost of mortgage for home owners. However, the Federal Reserve as well as others claimed that, the reduction in the cost hardly occurred but instead, the institutions took the advantage of the funding in racking up high profits. The two institutions aimed to remove private sectors from the “conforming” market regarding mortgages. Several firms and other foreign governments perceived the debts of the two financial institutions as a substitute for the securities in the United States and therefore snapped the debts eagerly (Coleman, 2008).
Research indicates that, the weak supervision on Fannie and Freddie caused them to lose focus on their core mission. Consequently, the subsidized financing was used by Fannie and Freddie in buying securities that were mortgage-backed and which were in turn backed by pools that lacked usual standards. It was during 2007 when it was clear that, Fannie and Freddie were operating on a thin capital that could not cover the losses on the subprime mortgages. The large amount of debt that was diffusely held was feared because it would have resulted into collapses allover if defaulted upon. This led to the treasury announcement that it would intervene to explicitly guarantee this debt. However, even when the debt was guaranteed as secure and the government promised to wipe out shareholders as a condition in offering the guarantee, self-interested investors were not willing to give more supply of equity in buffering the losses. This led to the treasury taking over the debt. Therefore, Fannie and Freddie Mac were cogs in the mess but not proximate cause of boom, burst or resulting credit collapse (Coleman, 2008).
Conclusion
The liquidity generated by Fannie and Freddie provides a huge margin that sustains the size of the housing mortgage market without which, there would be no housing bubble. Functioning of the housing bubble is only possible if it is able to push up the home prices and this in turn is only possible if there are mortgages to purchase homes at increased prices. Were it not for Fannie Mae and Freddie Mac, the market for home mortgage would be about a quarter in sizes as it was. On the other hand, the two institutions have raked large amounts of profits attributed to the housing bubble. However, an enormous exposure to debts of mortgages has also been concentrated in these two institutions. Currently, although the housing market is dependent on Fannie and Freddie, the two are in a rotten condition enough to puncture the bubble itself which they are supposed to be supporting and this is a great irony (Coleman, 2008).
References
- Coleman M. (2008): Subprime lending and the housing bubble: Elsevier
- Eisenbeis R. (2007): An Analysis of the Systemic Risks Posed by Fannie Mae and Freddie Mac: Springer
- Michael W. (2007): Emerging Competition for Fannie Mae and Freddie Mac: Blackwell Synergy