Fannie has been a Bad Girl
Fannie Mae has been in the news recently, as its executives manipulated the company's accounting to fulfill goals that awarded large bonuses
May 1, 2006
Fred Foldvary, Ph.D.

Fannie Mae is a government-sponsored enterprise, as are Ginnie Mae and Freddie Mac. The Federal National Mortgage Association (FNMA or Fannie Mae), Government National Mortgage Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) are all "secondary market lenders." Fannie and Freddie subsidize the real estate mortgage market by buying mortgage loans originated by banks and other lending institutions. They also package mortgages and sell them to insurance companies, pension funds, and other financial institutions as mortgage-backed securities.

Fannie Mae has been in the news recently, as its executives manipulated the company's accounting to fulfill goals that awarded large bonuses. Fannie's board of directors failed to catch the accounting irregularities, and Fannie has been spanked with $400 million in penalties, while its former executives face possible charges. The Office of Federal Housing Enterprise Oversight reported that Fannie's accounting practices do comply with standard principles, and the firm has faulty financial reporting, internal controls and corporate governance.

Fannie Mae was created by Congress in 1938 as a government agency to buy mortgages from lenders, creating a secondary market for loans insured by the FHA. Congress had created the Federal Housing Administration in 1934 to prop up real estate by providing governmental mortgage insurance for lenders. The federal government has also created the Government National Mortgage Association, GNMA or Ginnie Mae, to provide subsidized loans. A bank can originate a below-market loan to a low-income borrower, and then sell it to Ginnie Mae at full market value; the government pays the difference.

Fannie Mae became nominally private in 1968, and measured by assets, is the third largest US corporation. But Fannie is still tied to the U.S. government. One third of the board is appointed by the US president, and the US Treasury is authorized to lend Fannie Mae money if needed for its operations. Though not legally obligated to bail out Fannie Mae, the implicit guarantee by the U.S. government has reduced the risk premium on the bonds issued by Fannie. The effect of the mortgage guarantees is to reduce the interest rate on mortgages, subsidizing home buying.

After 1968, Fannie Mae no longer provided loans directly to homeowners, so the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) was created in 1970 to handle a secondary market for conventional real estate loans, those not secured by FHA.

Fannie has been bad not just because of the accounting scandal but fundamentally bad for the economy. Freddie too has been a naughty economic boy. The promotion of mortgage-backed securities by Freddie and Fannie in the 1970s led to a huge increase in mortgages. The subsidized secondary market combined with high inflation to fuel the speculative rise of real estate prices that ended in the recession of 1980.

Fannie, Ginnie, Freddie are the three stooges of U.S. government intervention in real estate. These economic delinquents work with deposit insurance and fiscal subsidies to goof up the U.S. real estate market. Bank deposits are guaranteed by the federal government up to $100,000, so banks face less risk when they loan for real estate purchase and development. Bankers sell their mortgages to Fannie and Freddie, which in turn sell bonds to the public. With these guarantees and mortgage resale markets, banks go hog-wild, lending out interest-only mortgages and adjustable-rate loans to buyers with not so good credit.

Meanwhile, land values get pumped up by governmental services and works that landowners don't pay for, while real estate gets tax privileges, as owners can deduct property taxes and mortgage payments from taxable income, while those "investing" in real estate get a fictional depreciation deduction. Owner-occupied housing gets a large capital-gains-tax exemption, and those speculating in real estate can sell one property and buy another with a postponed capital gains payment. These are the fiscal subsidies that privilege real estate relative to other assets.

But, as the wise King Shlomo declared, "vanity of vanities; all is vanity" (Ecclesiastes 1:2). All these subsidies are in vain. If real estate has more gains than other assets, its price gets bid up until the gains, relative to risks and taxes, are equalized with those of other financial assets. What real estate owners get in lower taxes and lower mortgage interest, they lose in having to pay a higher price for land, so the mortgage payment gets back to what it would have been without the subsidy.

Another bad effect of these government-sponsored enterprises is that the whole economy has now become vulnerable to a collapse of real estate prices. As mortgage derivatives have become a large portion of the portfolios of insurance companies, mutual funds, pension funds, and other firms, a downturn would shake the entire economy and not just the banks. If the governmental guarantee becomes explicit and actual, then the government would have to borrow hundreds of billions of dollars to bail out Fannie and Freddie, on top of already huge deficits, which would increase interest rates and make the recession and depression that much worse.

Fannie seemed like a good idea during the Great Depression, when real estate construction came to a halt and land values collapsed. But like other New Deal measures, it treats symptoms rather than confront causes. We need to get rid of the three housing stooges and let the free market handle mortgages.

But to have a truly free market in real estate, the government has to eliminate the taxation of human action and its products, and stop its fiscal subsidy of landowners. A pure free market in real estate requires free-market money and banking and the tapping of land values to repay to government the site values created by state-provided works and services. Either that, or privatize community services so that civic associations provide the works and collect the assessments to pay for them.

Fannie has been a bad girl, but the Fed, the IRS, and the state chiefs have all been economic delinquents. The pure free market is not a radical policy. Freedom is natural and enriching. What is extreme is the amount of government intervention, but we have become so used to it that we only see Fannie's financial scandal as bad and not the far worse greater delinquency of the totality of governmental interventions.

The voters are the ultimate bad boys and girls as they keep electing the system that creates the boom and bust cycle and keeps many in economic insecurity, deprivation and conflict. If Fannie was naughty, so are the government chiefs responsible for her and the voters that elected these chiefs. Fannie was spanked, but the public will be punished much more badly in the next depression, and sadly, they won't know why.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., (May 11, 1946 — June 5, 2021) was an economist who wrote weekly editorials for since 1997. Foldvary’s commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary’s areas of research included public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.