The nationalization of America’s mortgage problem

By Edward Harrison of Credit Writedowns. I wrote this in September 2008, re-posted it at Credit Writedowns in March and am re-posting it here because of Yves’ last post.

Ifelt that Fannie and Freddie would be used to buy up mortgages, effectively nationalizing the U.S. Mortgage problem (see my last paragraphs). I had seen this as the likely result when the GSE were first put into conservatorship, but the Bush Administration was opposed to such an outcome. Let’s give them credit there. However, I said in March, this is ever more likely now that Obama is in office. And, indeed, it is. Feel free to comment about alternative solutions, about which I ask at the end.

Here is the original post as written on 11 September 2008 right after the GSEs were nationalized.

This is a topic I first broached in May. The United States has a mortgage problem in that house prices have fallen so much and the financial sector is so leveraged that the U.S. faces systemic banking risk from a vicious circle in the mortgage sector. (I normally might have said ‘negative feedback loop,’ but my good reader dearieme pointed out I was misusing the term)

This circle leads from house price declines to foreclosures to bank losses to bank deleveraging and credit tightening leading to more house price declines and on it goes.

Enter Hank Paulson.

By taking over the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, Paulson can use the two companies, now under government control, to provide fresh liquidity to the mortgage market.

Roots of mortgage nationalization in depression
You see, that is why Fannie Mae, and later Freddie Mac, were created in the first place. On Fannie’s website, it says:

Fannie Mae was created in 1938, under President Franklin D. Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America.

The government established Fannie Mae in order to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home.
Fannie Mae

In essence, the Great Depression caused great hardship for Americans because of the destruction of America’s financial system after a wave of bankruptcies in the banking sector. Let’s go back to that painful period of American history.

Bank runs
During the Great Depression, the United States suffered from a similar difficulty of high financial sector debt (see chart below for statistics on debt increase since WWII)coupled with asset losses, eroding banking capital. The result was a loss of confidence in the banking system, causing people to withdraw their deposit money from a number of institutions. These deposit withdrawals created rumor mills that whipped the public into a panic whereby certain banks were deemed so risky that many depositors withdrew funds, so many that the banks were declared insolvent. This is the definition of a bank run, and is exactly what happened to Northern Rock in the UK in 2007.

Funny thing though, insolvent banks don’t lend money because they don’t exist. Therefore, the wave of bank runs and bank insolvencies that resulted from those runs reduced available credit in the system. Hence, irrespective of whatever liquidity the Federal Reserve supplied, the economy — starved of credit – was destined to decline. And decline it did, with output falling 46% in nominal terms and unemployment peaking at 25%.

Mortgage lending
As one could imagine, getting a mortgage in those conditions was pretty difficult. Bank capital was husbanded tightly out of banks’ logical fears of being the subject of the next bank run. Moreover, back then, there were strict interstate banking laws (laws that were only repealed in 1994.) So that meant that a lender was beholden to the local economy — if an area hit the skids, so did its bank, reducing credit availability and further depressing the local economy.

Enter Fannie Mae. Fannie Mae was created as a government agency to eliminate the restriction on mortgage credit availability – exactly the problem we are now experiencing.

Fannie Mae was founded as a government agency in 1938 as part of Franklin Delano Roosevelt‘s New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States.

In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, it was converted into a private corporation. Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae).


In 1970, Freddie Mac was created, in order to further expand the government’s role in creating a market for mortgage availability.

The FHLMC was created in 1970 to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgages lending and increases the money available for new home purchases.

One might believe for ideological purposes that the government should not be involved in the mortgage market because it distorts investment decisions. I have sympathy for that argument.

However, I also realize that it is times like these that necessitate government’s participation in markets on some level. The U.S. banking system as a whole is clearly undercapitalized and institutions are fearful of becoming the next Bear Stearns or Northern Rock. Therefore, liquidity has evaporated in the money markets and in the mortgage market. As a result, in the mortgage markets, before their conservatorship, Fannie and Freddie were responsible for 3/4 of mortgage lending in the US, up from 50% pre-crisis.

There is little the Federal Reserve could have done to correct this problem. The Fed has already done as much as it can — I would argue more than is prudent — to prevent another Depression-like scenario. It was high time, the U.S. government stepped in to do something. Congress, as useless as ever, did not provide a solution. Therefore, it was up to the executive branch to show some leadership on this issue. And Hank Paulson stepped into the breach.

I do not like many features of his bailout plan because they do not eliminate the moral hazard that was complicit in creating the mess in the first place. His plan is also very political. It protects debt holders like China’s central bank, which holds $400 billion in GSE debt. It protects foreign central banks generally, as they hold $1 1/2 trillion in GSE debt. It protects the likes of Bill Gross, who took a calculated risk in feasting on GSE debt, betting that such a plan was likely to happen. The plan does not wipe out equity capital, nor does it wipe out preferred equity holders entirely. These capital classes should bear all of the initial risk to future capital losses, not U.S. taxpayers.

Moreover, there will be the sticky points of the government running and exiting from Fannie and Freddie. Will politics become an increasing factor in GSE decision-making? How will the GSE’s attract top talent now that the profit motive is gone? How will the government extract itself from the GSEs: will it wind down Fannie and Freddie, hold on to them, or privatize them in part or in full? All of these questions need to be answered.

But Paulson’s plan will be effective on many levels. It will certainly give the mortgage market a boost by lowering mortgage rates and increasing liquidity. This will have the net effect of putting a floor on house price declines in the U.S. and eliminating one of the principal risks to the banking system. And I suspect that the U.S. government will actually increase the GSE’s lending in order to do exactly that. Of course, taxpayers will foot the bill on any lending losses.

So, there you have it. The mortgage problem in America has effectively been nationalized – socialized, if you will. Welcome to the United Socialist States of America. This is certainly not a desirable outcome for the bastion of capitalism that the USA believes itself to be.

But, is there any other solution? Personally, I think not. What do you think?

Update: I may have felt GSE nationalization was necessary then but nationalizing the mortgage problem aka socializing bank mortgage losses to taxpayers is an example of crony capitalism. It is kleptocracy.

Unemployment Rate, U.S. Bureau of Labor Statistics
Federal Reserve Flow of Funds, Federal Reserve

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. clownshoes


  2. Jon Claerbout

    … it is times like these that necessitate government’s participation in markets on some level

    I do not agree, and here is why: The government could instead offer generous loans to taxpayers based on their paying history. Many would use the money to pay down their mortgages, putting money in the hands of bankers, saving the banks. My proposal does not transfer money from one class to another; it transfers money from taxpayers to taxpayers, hence it is value neutral, politically acceptable, and thus scalable to any needed degree.

  3. funkright

    Funny thing, if we just ran the monetary system in a way that benefited the citizenry (as a whole) we wouldn’t have this issue.. The founding fathers of the USA intended that to be the case and was one of the main reasons for the American Revolution.. Accepting the monetary system for what it is and being unwilling to change it will cause this ‘doom cycle’ to continually run its course.. Read Web of Debt. There is a better way.. We just need to chose it.

  4. Gaucho

    Ed, just one comment: Fannie and Freddie rescues have effectively wiped out common and preferred shareholders, given that govt’s preferred is senior to existing preferred. that’s the way it should have been for all bank rescues. But using Fannie and Freddie as the poster child was wrong given that FAnnie and Freddie marketed their preferreds as govt sponsored entities with the implied guarantee from the govt. Fannie and Freddie were grossly undercapitalized, but they could get away with that based on their status as government sponsored entities and the implied govt guarantee. that’s the only reason they could raise preferred at a low 8.50% despite its low tangible equity. This was all politics, Republicans hated the GSEs. but in the case of Fannie/Freddie preferred (which was truly another form of sub debt), it was also silly, because paulson killed the market of preferred stock in all its forms(including mandatory convertible preferred, etc), which plays a key role in bank capitalization. what else can you expect from the clowns that were trying to fix the financial system with no experience whatsoever dealing with financial institutions.

  5. Lyle

    A slightly cynical view of why Fannie and Freddy exist: Recall the slogan “Workers of the world unite you have nothing to loose but your chains” If you “own” a house you suddenly have something to loose. So starting with Hoover and continuing thru every administration since the goal has been to increase home “ownership” in order to pacify the populace. In other words Fannie and Freddie and Ginnie are riot prevention programs. Politicans put this in a positive spin by saying homeowners are more invested in their communities, but by changing the sign one can derive an ulterior motive.

  6. Tim Coldwell

    If nothing is done to encourage house prices to drop to affordable levels then only time and very significant inflation will reduce the pain and normalise the housing market. Protecting any GSE creditors is a dumb policy no matter who they are. Don’t expect much productive entrepreneurial sprit to create new companies and hence jobs from those who are worried about something as fundamentally important as a holding onto their family home.

    The question, therefore is, should a government help to finance homes on reasonable well established stable (aka fixed) terms or start ups like expert venture capitalists?

  7. Kirk Powell

    A solution. Don’t fix what isn’t broken. At what point did deflation become a dirty word? We don’t need to fix the natural cycle of deflation that should occur withing the monetary system. Deflation is only a problem for those holding assets … not everyone else.

    Government solutions are only necessary when society has ventured beyond what is reasonable. Slavery. Totalitarianism. The Simpsons …. uh, I mean mass-media.

    Deflation isn’t incorrect or wrong. It must occur. Trying to prevent the natural process of the economy further disenfranchises everyone who was willing to pay their dues in order to drink from the golden cup of opportunity.

    Trillion dollar bailouts means that there is no opportunity. There is no reward for a lifetime of hard work. The entire capitalist system has morphed into a liberty-hating fiat government of communist corporations.

    End the Federal Reserve System. Stop borrowing the national currency from a private bank. Wage-slave-debt is not prosperity … nor liberty.

  8. killben


    What are you trying to salvage …

    A losing business plan
    Extend & pretend
    Hide & hype

    Does this benefit anyone except ..

    Politicians who can con the public
    Guys at the institutions who are getting paid wall-street style

    Unless you learn to acknowledge that you are supporting an unviable business entity how will you ever correct the ship

    You cant make loans on a collateral with falling values without going bankrupt one day .. it is only a matter of time .. by then a problem of say 500 billion would have become 5 trillion

    This is just another way to screw the tax-payer in the guise of helping the main street.

    I feel common sense will tell you that

  9. Nexus

    US policy re. the criss has fundamentally failed – the day of reckoning has been simply been postponed. The banks should have been ‘nationalized’ then restructured and returned to private operation based on new commercial rules – the ones developed in the 1930’s and repealed would be sufficient.

    Mortgages in the mortgage companies should have been converted to very low interest government loans to keep people in their homes (and spending on goods and services).

    Al that has happened is a massive amount of resource (treasury) has been transferred to the parasitic bankers at a fantastic cost to rest of US society as they only way the debt can be reasonably managed is for welfare, education, health, etc, to be cut back massively.

    As for the US being the bastion of capitalism don’t make me laugh as it has always had one of the largest planned economies in the work – one which dwarfed the USSR. The industrial military complex which is now leading the US to ruin by sucking scarce resources from the rest of the economy.

  10. Rishi

    a) Inspite of giving the bail-out money, the government does not get ANY stake. This is ridiculous. At least if they had a stake in return for giving money they could have sold it later and encashed it gradually and de-nationalized.

    b) alternatively, they could have given money to the defaulting home-owners. That way the lenders would not have been out of business AND there would not be homeless people. Now you have unemployment AS WELL AS homelessness. How sane is it to double the problem from political stability point of view?

  11. Spencer Bradley Hall

    Ecnoomists have been a day late, and a dollar short. Instead of discipling the banks, politicians gave the S&L’s, MSB’s, & CU’s the power to create new money & credit. This destroyed the financial intermediaries and left it impossible for the FED to control the member banks.

    Trillions of deposits were diverted/shifted into time/savings deposits; liabilities that could be transferred on demand, without notice, and without income penalty, a type of auxiliary money (consequently leaving the money stock unknown, and unknowable).

    Written in June 1980, the DIDMCA: “One of the principal purposes of the Act was to provide the housing industry with a reliable source of funds. That may be ACHIEVED THROUGH VARIOUS GOVERNMENTAL AND QUASI-GOVERNMENTAL CORPORATIONS. But the role of the S&Ls in housing finance will probably diminish significantly” Leland James Pritchard, PhD, Economics, Chicago, 1933, MS, Statistics, Syracuse

    Dr. James Hamilton at Jackson Hole: “Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3….” – Credit Crunches, Bank Runs, & Regulation.

    Member banks pay for what they already own. Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    The effect of allowing member CBs to “compete” with financial intermediaries (non-banks) has been to reduce the size of the intermediaries/non-banks, reduce the supply of loan-funds (available savings), increase long-term interest rates, & increase the proportion, and the total costs of CB TDs.

    Thus, IOR’s have caused the member bank portfolio’s to be shifted, from low yielding T-Bills (& vault cash), into the higher yielding, risk-free, IORs @.25%. It is not an exaggeration to say that a trillion dollars of IOR’s have been diverted, from productive assets, to non-productive assets. At one point on November 19th, the yield on a new 3-month U.S. T-bill fell to 0.005%.

    So why have economists let this happen?

  12. Bruce C.

    In my opinion, what should have been done or what could have been done, is moot. The government’s involvement in the economy is what creates distortions but that also increases its power. The “solution” is for government to extract itself from the economy and remove the false sense of security that its presence creates. Then the market can operate as efficiently as possible resulting in much smaller or at least less broad imbalances. The problem is that the gov. does not want to relinquish power and the process of its extraction would be painful to many and considered politically untenable. Until the majority of US tax payers primarily, and all other investors secondarily, are willing to take the hit to re-establish what the founders/constituition intended then every “solution” is going to involve ever-greater levels of government involvement until everything collapses. I think most people would prefer to experience the interventions and patch-work efforts that are now occurring and will continue, each participant hoping that he/she will somehow benefit. Unfortunately, that same pragmatism is what justified what was done in the past and that got us to where we are now. Ironically, “the hit” that most seem unwilling to accept will still occur, but more slowly and extensively than it otherwise would be.

  13. ex VRWC

    Its simple.

    There are too many houses.

    There are too many apartments.

    You subsiduze people getting into houses, and the apartments go empty. Rents go down. You kill the banks by another means You rob Peter to pay Paul.

    its called overcapacity.

    Housing is a religion, an idol in this country and throughout the world.

    We pay too much for shelter. It is out of proportion.

    It needs to go down. The government should let the market do its work.

  14. NC Jim

    To call the recapitalization of Fannie “nationalization” or (worse) “socialization” is misleading in that it suggests a desire for permanent government ownership as with a South American dictator or the like instead of a temporary bailout.

    I prefer the term “pre-privatization” coined by Calculated Risk somewhat tongue-in-cheek. This more accurately describes the intent.


  15. Blissex

    «Recall the slogan “Workers of the world unite you have nothing to loose but your chains” If you “own” a house you suddenly have something to loose. So starting with Hoover and continuing thru every administration since the goal has been to increase home “ownership” in order to pacify the populace. In other words Fannie and Freddie and Ginnie are riot prevention programs. Politicans put this in a positive spin by saying homeowners are more invested in their communities, but by changing the sign one can derive an ulterior motive.»

    That’s not quite complete. There is quite a bit of political science research that shows that homeowners, like stockowners, carowners etc. tend to vote for right-of-centre parties and conservative, authoritarian policies. It has thus become a priority goal of the business and political elites to turn as many suckers as possible into petty landlords, with a mean, greedy rentier landlord outlook and voting patterns.

    The result has been in the past 2-3 decades a very sharp shift of politics to the right, where currently progressive democrats are considerably more authoritarian than most republicans in the 50s, and where voters, who are 70% home and stock owners, constantly reward politicians that redistribute income to them with huge capital gains arising from asset price bubbles.

  16. Blissex

    «To call the recapitalization of Fannie “nationalization” or (worse) “socialization” is misleading in that it suggests a desire for permanent government ownership as with a South American dictator or the like instead of a temporary bailout.»

    But the losses of the GSEs and of the TBTF investment and commercial banks are now known to be backstopped forever by the government; the implicit government guarantee has been made effectively explicit, as recognized here:

    «It protects the likes of Bill Gross, who took a calculated risk in feasting on GSE debt, betting that such a plan was likely to happen.»

    When Bill Gross made his bets there was still some uncertainty as to how far the government would make whole the creditors of TBTF financial speculators; not any more, now it is pretty much official that profits are private and losses are socialized.

    «I prefer the term “pre-privatization” coined by Calculated Risk somewhat tongue-in-cheek. This more accurately describes the intent.»

    But a privatization like that in the 60s privatizes the profits but not the losses. Private interests have raked it in for decades, taking on colossal risks, knowing that when the risk materialized the government would blink.

  17. ZA

    If the government was interested in the citizenry, half the money that’s already been committed to backstop banks, derivatives and bank debt would have already purchased every mortgage in the country.

    And I agree with the commentor above – in every other arena, the Fed seems to welcome and even encourage price deflation, in the form of real wage stagnation, technological “productivity gains” and imports made cheap by global wage arbitrage.

    Why on earth, in an aging nation with flat population growth, would a *used house* inflate, any more than a used car?

    Banks thrived for centuries without any concept of securitization. They chose this course of action and they and their investors alone can live with the consequences. Fannie and Freddie funding should be subject to an up-or-down vote in Congress so we can end this backdoor bailout.

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