Live from Austin!

Once upon a time, the US government set up three agencies to provide home loans to people.

The Federal National Mortgage Association (FNMA) was founded by FDR to improve the liquidity of the mortgage market. It sits in between the mortgage borrower and the lender. Its job is to assume the risk of mortgage default, in return for a fee. In the 1960s, part of it was removed from the federal balance sheet by spinning it off into a private corporation. It was replaced by…

The Government National Mortgage Association (GNMA), part of the Department of Housing and Urban Development (HUD). GNMA bundles mortgages into securities which it guarantees even if the mortgages default, and then sells them on to big investors. It handles mortgages for veterans and native Americans.

The Federal Home Loan Mortgage Corporation (FHLMC) was set up in 1970. It basically does the same job as the FNMA, and was set up to provide competition for that organization.

In addition, the The Federal Agricultural Mortgage Corporation (FAMC) provides loans for agricultural real estate and rural housing.

Finally, the Student Loan Marketing Association (SLM) was set up to provide federal student loans.

Before long, people working in the housing industry came up with names that were easier to say and remember than the abbreviations the government used. FNMA became known as Fannie Mae, after the candy company Fannie May. GNMA became known as Ginnie Mae, and someone came up with Freddie Mac for FHLMC, presumably because the H is silent.

By the mid 80s, all the government agencies were called Mae or Mac; the FAMC became known as Farmer Mac and SLM became known as Sallie Mae.

Once the slang names became sufficiently entrenched, several of the organizations decided to officially change their names to the slang versions. Hence, FNMA’s logo officially says FannieMae, and FHLMC’s says Freddie Mac.

Before long, some private corporations worked out that they could suggest that they were big government-backed outfits by naming themselves something ending in "Mae" or "Mac", without technically lying to customers. Hence a bank in Pasadena called itself IndyMac, and one in Brea called itself ResMae.

Fannie Mae and Freddie Mac have ended up guaranteeing almost half of the mortgages in the US, for a total of around $5.3 trillion. Since they were officially run as private corporations, they were able to spend a lot of money ensuring that they remained unregulated and able to invest in subprime mortgages–i.e. mortgages that the borrowers would never be able to pay back, in quantities large enough to ensure that the CEOs and shareholders of the lending companies would get rich.

So as the housing bubble has started to collapse, so has Fannie Mae’s stock price. (Check the 1 year or 5 year graph.) Freddie Mac’s stock price has been just as ugly.

Now, as already mentioned, Fannie Mae is (strictly speaking) a private corporation. However, over the years they have bent the rules and implied that the US government backs their loans. It wasn’t true, but by lending unwisely they’ve become so big that the government now thinks it can’t afford to let them fail. So last weekend, the the Treasury Department and Federal Reserve announced that they would make funds available as necessary to keep Fannie Mae and Freddy Mac solvent.

In other words, last weekend the US government effectively added up to $5.3 trillion to the national debt, which is an increase of 50%.

So ironically, by a year or two ago the situation had become so dire that IndyMac and ResMae found themselves with names that had negative connotations. ResMae collapsed last year, and now IndyMac has collapsed.

Now, in the event of a US bank’s collapse, individual consumers are protected by the Federal Deposit Insurance Corporation or FDIC. Basically, the government guarantees your money won’t disappear if the bank collapses, up to a limit of $100,000 per person.

Unfortunately, the FDIC doesn’t actually have enough money to bail out all the banks that are expected to crash. In fact, before IndyMac crashed they had funds to cover just 1.19% of the total insured deposits. After IndyMac, they dropped below the legal mandatory minimum of 1.15% coverage.

Theoretically, the FDIC gets its money by charging premiums to banks who wish to assure investors that they are FDIC guaranteed. So the problem of bailing out the FDIC will be passed on to the average taxpayer, in the form of higher bank fees. And if that fails, the taxpayer will be forced to bail out FDIC directly.

Some analysts are now comparing the fiasco to ENRON. Except this time, it’s an ENRON where the taxpayer has to bail out the crooks. So, another great victory for reduced government regulation and the free market.

Update:

On 2008-09-08, the US government formally took FNMA and FHLMC into public ownership making the bailout official. While not every loan is going to be defaulted on, the taxpayer is potentially on the hook for the entire amount; it’s on the balance sheet as a liability.

The mainstream media coverage of the US subprime mortgage meltdown has mostly been about all the folk who have lost their homes, and various plans the government has come up with to try and ease the problem. Thinking about it more carefully, though, doesn’t it seem a little odd for the US government to interfere in the sacred free market merely in order to save a bunch of poor people from ruin?

Well, the SF Chronicle has an interesting article that explains this curious situation. It’s not about saving people from losing their houses, it’s about saving the banks.

During the housing bubble which was fueled by the subprime lending, banks sold mortgage-backed securities. For those who don’t know, mortgage-backed securities are basically in-place mortgage agreements, packaged for resell between financial organizations, or between financial organizations and investors.

The key is to view a mortgage in the abstract, as a promise by person A to pay an amount X for N years. That promise has a value, and can be sold.

For example, we arranged our mortgage through a small financial firm in the Austin area. Once all the paperwork was done, they packaged us up as an asset and sold us to GMAC. GMAC took on the business of extracting money from us over the course of years, and paid the small financial firm a lesser amount in compensation for the value of us as a customer.

This is generally a good thing. Because GMAC does administration for millions of mortgages, they can provide convenient billing and payment services, and reduce per-customer overheads. For the small firm, the benefit was immediate cashflow and no ongoing overheads.

A similar process can be used to package a mortgage and sell it to investors as a bond. The bank gets to remove the liability from their balance sheet; they can then use the cash to provide mortgage funds to more homebuyers. Hence, allowing the transfer of mortgages as mortgage-backed bonds should allow more people to buy their own houses.

For example, suppose John Smith owes the bank $1000 a month for the next 20 years. That’s a total of $1,040,000. The bank could sell that mortgage to an investor as a bond for (say) $750,000. The bank would get the $750,000 immediately, reducing their liabilities. They could use the money to finance some new homebuyer’s mortgage. Meanwhile, the investor would get $1,040,000 over the course of the next 20 years, making a nice profit. And the whole thing could be treated like a regular bond or stock market investment–the bank could continue to process the collection of the actual mortgage payments, just like it would process dividends on a mutual fund investment.

The problem is that since the banks expected to sell off the mortgages to eager investors hoping to cash in on the property boom, they didn’t really care too much about checking that the mortgages were sound; and the investors didn’t really have any way to check on the actual person paying the mortgage.

However, there’s language written into these mortgage transfer securities stating that if there’s fraud, the bank which sold the mortgage is legally obligated to offer to buy it back at the original price–which is now often ten times the actual value likely to be extractable from the homeowner. Fraud like, say, people lying on their mortgage applications, or inflated property appraisals, or e-mails on bank computers suggesting that they knew the market was a bubble that couldn’t last. Then there’s the issue of companies like S&P, who helped the banks to structure the subprime mortgage securities to look as good as possible on paper.

So if too many mortgages fail, and investors start demanding that their junk bonds be repurchased by the selling banks, those banks will go under. At that point, the FDIC and the government will have to step in, and we’ll basically have a taxpayer-funded bailout of a bunch of big corporate banks who defrauded investors. It’ll be the Savings and Loan crisis all over again.

How about pressuring the investors not to call in the cops? Well, unfortunately a lot of the investors are in foreign countries. Some of them are foreign countries. With the current state of US diplomacy, a conversation that starts with “Hey, we were wondering if you could eat a few billion dollars in losses to fraud so that we don’t have to bail out our rich corporate buddies in full public view” might not go too well.

But never mind, it may not come to that. A crack team of financial experts are trying to come up with a way to salvage the situation. We know they’re experts because, as the Chronicle points out, they’re exactly the people who got us into the mess in the first place…

Everyone should have a chunk of cash in an instant access savings account; see Dilbert’s guide to financial success.

If you’re in the US and have $250 spare to put in a savings account, I’ve got a voucher you can use to open an account with ING Direct, and they’ll give you $25 free. (Plus $10 for me.)

I’ve been saving with them for a while, because their rates are so much better than my bank’s savings account rates (4.4% APR with no fees). They’re a proper FDIC insured outfit backed by a real bank, a European multinational. I briefly had all the proceeds from selling my UK apartment in the account, and they didn’t abscond with it, so I’m pretty sure your $250 will be safe.

Also on the subject of free money, a while back Bank of America bought MBNA. I have MBNA credit cards; naturally I pay off the balance each month. Based on my transaction history, Bank of America have sent me mail saying they’ll pay me $100 to open a checking account with them. Maybe I’m crazy, but I haven’t rushed to do so. A quick glance at the relevant Wikipedia page and you’ll see that Bank of America has engaged in various sleazy business practices.

My current bank is Wells Fargo; they have a much cleaner record, and I also get the joy of knowing I’m supporting a company that really irritated Focus in the Family. Plus, they were the only US bank I could find that had all the necessary information about how to transfer money internationally available on their web site.

Update 2006-11-15

A customer was worried that a check for an eBay transaction might be fraudulent, so he asked Bank of America to examine it carefully. They said it was on a valid account, so he asked them to cash it. Then Bank of America changed their minds and decided the check was fraudulent, called the cops, had him put in jail, and effectively wasted $14,000 of his money on legal hassles.

OK, now I’m really sure I don’t want to do business with Bank of America.

Fleet Bank is heavily invested in Argentina—where the economy has collapsed, and Fleet is having to restrict customers to withdrawing less than $1000 a month.

Meanwhile, Fleet has taken a hit of $1.8 billion to cover the money it’s lost in South America, with an overall loss of $507m in 4Q2001. That’s half a billion dollars worse than they predicted. Profits for the full year were down 75%.

Still, your account is FDIC insured, so if the bank goes belly-up the federal government will bail you out. Eventually.