by Henry Oliner

The history of Fannie Mae and Freddie Mac dates back to FDR and LBJ. Their mission was to provide mortgage loans to middle and lower income citizens. But like so many popular government programs (including health care) they want to provide more benefits than they are willing to pay for.

Mortgage lending like any other lending is relatively simple. You will loan based either on the value of the asset or based on the ability of the borrower to pay it back. To guard against the drop in the price of the asset, you will protect yourself by asking the borrower to put up a down payment. In the 1960’s and 70’s you generally expected to put down 20% of the price of the home in order to borrow the remaining 80%. You had to prove yourself a dependable income source with a good credit history and a good personal history from either education or job recommendation.

As housing prices grew the 20% down payment became onerous and the politicians wanted to help the poorer realize the American dream of home ownership. Down payments slipped to 10% or even less, often with a higher accompanying interest rate.

Under Reagan the interest on consumer loans such as credit cards was no longer deductable. People discovered, and banks pushed equity lines of credit. Simply borrow from the asset value of your home and pay off your credit cards with tax deductable interest.

Mortgage lenders started making loans of 100% or 110% or even 125% of the asset. This was the beginning of the end. When this many people believe that appreciation of homes is inevitable the top must be near. When home owners lost their jobs they would just walk away from the home and leave it to the bank. Having no equity they had nothing to lose. This was common in Houston during the oil bust of the 1980’s.

As local loans became commoditized, the security of the loan weakened considerably. Banks no longer kept the local loan on their books and profited from the cash flow of a quality loans of their own choosing that they owned; they were now paid fees to originate loans that were then sold and resold to Wall Street firms who marketed them as mortgage backed obligations.

The banks became distant from their loans, the fees became generous, and the quality suffered. Ridiculous incentives were paid to generate new loans with no penalty left for making poor loans. Short term pleasure for possible long term pain- the junkie’s dilemma.

To help people qualify for loans the financial institutions, with the blessings of the government regulators and oversight committees, invented ARMS, interest only, and then they just fudged appraisals and income qualifications. Creativity and rationalizations abounded to support popular delusions.

But at the core of this problem is that the government wanted to give something for nothing. By making loans available for people who could not afford them they ignored the long term risk, basically giving away risk coverage for free. This is like an insurance company offering you free insurance for your car and still expecting you to drive safe. Would you want to buy their shares?

The rest of the story is a story of fraud, cover up and politics designed to hide the basic and obvious truth. They distributed fashion awards (bonuses) to naked emperors.