Fannie Mae and Freddie Mac: a case study in the politics of financial reform

Author:Muhammad Islam
Position:Department of Economics, John Cook School of Business, Saint Louis University, St Louis, Missouri, USA

Purpose – The desirability of financial reform to avoid another financial melt-down is widely accepted, but the likelihood of reform is uncertain. The purpose of this paper is to present a case study of evolution and reform attempts at US mortgage giants Fannie Mae and Freddie Mac and provides an instructive model of the likely long-term success of attempts to reform the financial system. ... (see full summary)


No organizations were closer to ground zero of the real estate bubble and sub-prime mortgage melt-down than the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These US Government sponsored enterprises (GSEs) were created to provide a secondary market for mortgages, thereby increasing the availability of mortgage loans. They took advantage of favorable tax treatment and implied government guarantees to become the lead players in the US mortgage market before and after the bubble broke, requiring taxpayers to bail them out at a cost likely to reach hundreds of billions of dollars.

We examine the growth, influence, failure, and possible future of Fannie Mae and Freddie Mac. We particularly focus on the legislative process that has determined the historical and current structure of these GSEs. The rest of the paper is organized as follows: in Section 1 below, we present a general model of the legislative process. In Section 2, we briefly present the history of Fannie Mae and Freddie Mac along with a discussion of the proposals for reform and the objections to some of the proposals. Through this, we identify some of the key stakeholders in the legislative process including the management of the GSE's, advocates of privatization and fundamental reform of GSE's, and advocates of greater flexibility and access to low-cost mortgage loans for moderate to low income home buyers. In Section 3, we look at the various legislative attempts to reform Fannie May and Freddie Mac and the failure of such attempts over the last two decades. As the general model of the legislative process suggests, legislation ultimately is a compromise between the stakeholders having interest in a particular piece of legislation, and in the case of Freddie May and Fannie May, stakeholders often had strong incentives to derail laegislation, and acted to undermine lagislative efforts not to their liking.

1 A model of the legislative process

The US legislative process can be likened to an iceberg. While one can observe the visible mass of the iceberg, much of the process is hidden below the surface, and only individuals and institutions that have a strong stake in the legislation are aware of what lies underneath. These stakeholders protect their interest through the intense lobbying of legislators. Much of this lobbying is also absent from the public eye.

Though lobbying is often frowned upon and viewed as extraneous to the legislative process, it is an essential part of democratic law making, and provides a mechanism for interested citizens to participate in the legislative process. What appears as final legislation, however, is an outcome from a process involving many compromises among stakeholders, compromises that are not necessarily visible to an outside observer. Sometimes, lobbying is successfully able to derail legislation.

Legislation of any kind begins as an idea in what Birkland (2005) terms the agenda Universe. The agenda universe consists of all possible ideas that could be advanced in any society. The content of this universe changes over time. To illustrate the steps in this process, consider the examples of Equal Rights Amendment for women and of gay marriage. At one point in time, the former had a strong presence in the agenda universe, and the latter was not even mentioned. Now the situation is reversed.

The issue of gay marriage gained strength in the agenda universe to the point where it actually moved to what Birkland (2005) terms the systemic agenda, the place where items that could actually be considered by participants in the policy process reside. From there, it moved to the institutional agenda, the agenda of items actually being considered by governmental bodies. The final step in the process, according to Birkland (2005) , is making it to the decision agenda. This is the more public part of the process, where legislators debate and decide whether or not to pass a piece of legislation. The fate of both gay marriage and the Equal Rights Amendment floundered at this stage. Some state legislatures have endorsed gay marriage, others have rejected it. And the Equal Rights Amendment did not garner enough support in the state legislatures to be ratified as a constitutional amendment. The lesson here is that making it to the decision agenda is no guarantee of success. Moreover, less visible lobbying takes place at all points in the process, with proponents trying to move causes to the next agenda level and opponents trying to stop such movement.

As illustrated in Sections 2, reform of the two GSE's, Fannie May and Freddie Mac, has been under discussion, and therefore, part of the both the agenda universe and the systemic agenda, for almost 30 years. Throughout, academics, journalists and legislators have debated the pros and cons of the role of the GSE's in the mortgage market, and also the direction of reform, if any.

GSE reform has also made it on to the institutional agenda and has been part of legislative discussion in both houses of the US Congress. As discussed in Section 3, as far back as the early 1990s, both the House and Senate held hearings and proposed legislation to reform the GSE's. Movement to the actual decision agenda is helped by the presence of focusing events. For the GSE's two such events have played an important role in moving through the institutional agenda into the decision agenda. The first event was the GSE accounting scandal of the late 1990s that resulted in legislative calls for greater oversight. The second was the housing market collapse, and along with that the collapse of GSE finances requiring massive government intervention. The latter event has forced legislators to consider GSE reform, including privatization that would shield taxpayers from any future liability. It is certainly, now, part of the decision agenda. However, as we have seen, presence in the decision agenda does not necessarily imply that legislators will be able to resolve conflicts, and actually succeed in passing legislation.

As discussed briefly above, but detailed in Section 3 below, at each stage in the agenda-setting process, stakeholders will try to take advantage of the opportunities presented by focusing events, political turnover, and expert input to push forward or stall legislation. Lobbying by stakeholders can help move an issue through the next leve of the decision-making process. Conversely, intensive lobbying can also occur to stop movement through the decision process. With regards to GSE's, congressional committees held hearings, brought reform proposals to vote in various legislative committees, but could not move legislation out of committees for a vote of the entire congress. Sometimes, lobbying occurs not to oppose legislation, but to restrict legislation in such a way that the final outcome is not palatable for the other stakeholders, and efforts to legislate simply die.

2 GSE's (Freddie Mac and Fannie Mae): a brief history and arguments for reform

Fannie Mae and Freddie Mac (or just Fannie and Freddie) were created by the federal government of the USA for the purpose of increasing home ownership by increasing the supply of mortgage loans. More specifically, Fannie Mae and Freddie Mac were created to provide a second market for mortgage loans so that original lenders could free up their money for new loans.

Fannie Mae was created by the Roosevelt administration in 1938. Fannie Mae was a government agency, owned and overseen by the federal government. Fannie Mae's role was to buy government guaranteed mortgages from loan originators. The mortgages were guaranteed by the Federal Housing Administration, the Veterans Administration, and the Farmers Home Administration. The government was at risk because it guaranteed loans, but the guarantees made loans risk-free for Fannie Mae.

The goal of the government in creating Fannie Mae was to make more funds available for lower income and less credit worthy families. Fannie Mae appears to have been successful for a number of years in this regard.

The government's goals with regard to its involvement in the mortgage market shifted over time. 30 years after its founding, Fannie Mae was converted to private ownership as a publicly traded corporation. Although it was now privately owned, Fannie Mae was still a GSE with favorable tax status and an implied guarantee. Consequently, there was little competition from private companies.

The government moved to enhance competition in 1970 by creating the Federal Home Loan Mortgage Corporation to provide essentially the same services as Fannie Mae, thereby providing competition in the marketplace for the purchase of home mortgages. Freddie Mac was created as a government-owned entity.

1970 also saw government approval to purchase mortgages that were not guaranteed by the government. A year later, Freddie Mac issued its first mortgage-backed security. A decade later, Fannie Mae followed suit. The mortgages were not guaranteed by the federal government, but mortgage-backed securities were guaranteed by Freddie Mac and Fannie Mae. The era of risk-return decision making was thus ushered in for Freddie Mac and Fannie Mae.

In 1989, Freddie Mac joined Fannie Mae as a private company with publicly traded stock. This put both Fannie Mae and Freddie Mac in the position of private, for-profit companies, but with status as GSEs with implied government guarantees (which turned out to be real guarantees when the mortgage crisis hit). Fannie Mae and Freddie Mac had drifted a long way from the structure created in 1938. They had become the principal players in the home credit market. Credit standards for...

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