Freddie Mac second mortgage funding could foment financial crisis

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The 2008 mortgage meltdown and financial crisis never fails to be invoked whenever there is any pushback to excessive financial regulation. Progressives regularly bring up the dangers of a repetition of 2008 in fighting efforts to bring regulatory clarity to cryptocurrency or relax US implementation of the international Basel III capital rules.

Yet progressives are strangely silent on a current proposal to loosen rules on a government-backed entity that played a direct role in fomenting the toxic mortgages that led to the financial crisis. Freddie Mac is the government-sponsored housing enterprise (GSE) that, along with its sister GSE Fannie Mae, buys up the bulk of American mortgages. The two GSEs were taken into conservatorship in 2008 after the Treasury Department deemed them at risk of imploding.

Now Freddie wants to spread the risk to taxpayers and the entire economy even further by entering into the market for second mortgages. A broad array of experts are not happy about this. The GSEs have both implicit and explicit government guarantees of a bailout. Such a move could foment more inflation and even another financial crisis.

The GSEs were formed by federal legislation to stimulate the housing market by purchasing mortgages from banks. Congress and the administration of Franklin D. Roosevelt created Fannie in 1938 as the Federal National Mortgage Association, a government agency.  Then, as I explain in a CEI paper:

Some 30 years later, in an effort to get the expense of Fannie off the official government
books, Fannie was made quasi-private, with mostly implicit government support. In 1968, Congress gave Fannie a special federal charter and allowed it to sell shares to the public. Congress also furnished Fannie a line of credit for $2 billion from the Treasury
Department. In 1970, Congress created another GSE, a “little brother” to compete with
Fannie called Freddie Mac. Freddie also had a $2 billion line of credit with the Treasury

The Competitive Enterprise Institute has warned of the dangers the GSEs posed since we were formed 40 years ago. In his testimony before the House Financial Services Committee in 2000, CEI founder and then-president (now chairman emeritus) Fred Smith zeroed in on the privileges the GSEs had as government-backed entities, particularly the lines of credit with Treasury.

Smith made the point, as others did, that these explicit subsidies were a signal for a much larger implicit bailout the government would provide should anything go wrong. In his testimony, Smith made at the time what seemed to be a colorful prediction. He warned that though the line of credit with the Treasury Department “is only $2 billion today. It could be $200 billion tomorrow” if the GSEs were to implode.

In the years following Smith’s testimony, the GSEs began to loosen their lending standards. The GSEs were pressured by politicians and the subsidy-seeking housing industry to “roll the dice,” in the words of Rep. Barney Frank (D-MA), with “affordable housing” goals and looser standards for mortgages. Frank pushed this agenda during his time as ranking minority member, and later chairman, of the House Financial Services Committee in the first decade of the 21st century.

As American Enterprise Institute scholars Peter Wallison and Edward Pinto have documented, Fannie and Freddie began classifying as “prime” many loans earlier classified as “subprime,” because the borrowers had FICO credit scores of less than 660. These looser standards spread across the mortgage market, leading private banks to make loans of even lower quality and paving the way for the financial crisis.

Then in September 2008 , the government took over Fannie and Freddie to prevent their insolvency in the wake of the financial crisis. Though he was accused of wildly exaggerating the GSEs’ future price tag to taxpayers at the time, it turned out Smith had estimated their liability to taxpayers about right, as the federal government spent nearly $200 billion of taxpayer funds to prop them up.

More than 15 years later Fannie and Freddie remain under government “conservatorship” – with the government owning 79.9 percent of each – despite the GSEs having paid back to the government about 50 percent more than the government lent them. The objective of the government keeping them as wards of the state does not seem to be preserving their safety and soundness, but to force them to once again “roll the dice” on risky ventures that suit politicians’ and rent-seeking business lobbyists’ desires. The new proposal of Freddie Mac to purchase second mortgages is Exhibit A.

In April, Freddie Mac sought approval from the Federal Housing Finance Agency (FHFA), the regulator of GSEs, to begin purchasing second mortgages – also known home-equity loans – for borrowers where Freddie already owns the first mortgage. Such a move, a variety of experts warn, would foment financial instability, exacerbate inflation, and foster inequality by favoring relatively affluent homeowners who already have equity in their homes.

Furthermore, Freddie’s purchasing of second mortgages would do nothing to fulfill the GSEs’ stated goal of access to home ownership. As Norbert Michel, director of the Cato Institute’s Center for Monetary and Financial Alternatives, notes in Forbes: “It would be hard to defend this new proposal on the grounds that it might help increase homeownership. In fact, it’s so difficult that the FHFA isn’t even trying.”

Rather, Freddie states that “the primary goal of this proposed new product is to provide borrowers a lower cost alternative” to home equity loans and cashout refinancing that already exist to provide credit to homeowners in the private market.

As Michel remarks in response, “So now the express purpose of the GSEs is to help homeowners take on even more debt, above and beyond what they need to purchase a home.”

Once consumers get these loans Freddie would give them for equity in their homes, they could use it for just about anything. As CEI’s Smith noted in his testimony in 2000, when the GSEs apparently proposed or ventured into limited purchases of second mortgages, “A ‘home equity’ loan can be used for anything – Fannie Mae may well be financing Jacuzzis.”

There probably will be a lot of Jacuzzis purchased if Freddie ventures into second mortgages, as the beneficiaries of this program will be relatively affluent homeowners.  As Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City and now distinguished senior fellow at the Mercatus Center, notes, “Freddie Mac would be giving a significant subsidized advantage to its own borrowers over other mortgage debtors, mortgage-free homeowners, and renters.”

As with the first mortgages that defaulted in the 2008 crisis, taxpayers will almost certainly be holding the bag if something goes wrong with Freddie’s second mortgage venture. And given the potential size of this venture, something going wrong could have an outsized negative impact for financial stability. As Hoenig points: “Bank of America Securities estimates that Freddie Mac’s potential market for this product could be $850 billion. It goes on to note that if Fannie Mae were also to offer a similar product, the potential market would more than double to $1.8 trillion.”   

Even with no defaults, such new spending in the economy could exacerbate inflation. American Action Forum president Douglas Holtz-Eakin, former director of the Congressional Budget Office, notes in a brief, the spending enabled by Freddie’s purchases could “rival the detrimental impact of the Biden Administration’s 2021 American Rescue Plan that totaled $1.9 trillion – one part of the policy errors that caused inflation to jump from 1.4 percent to 9.1 percent.”

Further, Freddie’s proposal is a solution in search of a problem. The private sector provided more than $370 billion in home equity loans last year without Fredde’s help, according to the Federal Reserve. Many affluent homeowners would surely like to get these loans at cheaper rates. However, most would likely balk if they knew they would later be paying with higher inflation, a potential financial crisis, and government-created inequality.

 CEI Research Associate John Austin Hatch contributed to this post.