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Self-Fulfilling Prophecy: The Bailout Of Fannie And Freddie

This is part two in our three-part series on Fannie Mae and Freddie Mac. Read part one, "Kill Them, Bury Them," and part three, "What's Next?"

By the beginning of the 21st century, almost half of all the mortgages in America were made through Fannie and Freddie.

Fannie and Freddie were private companies, with shareholders and highly paid CEOs. But they'd achieved this dominance because of the implicit guarantee they had from the U.S. government.

Because the world believed the government stood behind them, Fannie and Freddie paid less to borrow money than any other financial institution in the country. This gave them a big advantage.

Despite the fact that the implicit guarantee had turned Fannie and Freddie into two of the largest and most powerful companies in US history, people continued to deny that the guarantee existed.

At the top of every security that Fannie and Freddie issued, right there in big black letters, it said, "This security is not backed by the U.S. government."

High-powered government officials from both parties also denied that the guarantee existed. In 2003, Democratic congressman Barney Frank put it this way:

There is no guarantee. There's no explicit guarantee. There's no implicit guarantee. There's no wink-and-nod guarantee. Invest and you're on your own. Nobody who invests in them should come looking to me for a nickel. Nor anyone else in the federal government.

And in public, Fannie and Freddie would "adamantly lash back at anybody who argued that there was in fact a government subsidy," according to New York Times columnist Joe Nocera.

But to some of the people who mattered — the ones who were buying Fannie and Freddie securities — the companies said something else entirely.

Scott Simon was one of those buyers. He works in the mortgage department at Pimco, the world's largest bond manager, and one of the biggest buyers of Fannie and Freddie securities:

"Fannie and Freddie in meetings with investors, whether it was us or anybody else, essentially just would sort of laugh and say, 'Well, you know the government will stand behind us,'" Simon says.

Truer words were never secretly spoken. But when the bailout finally did happen, it happened in a way almost no one would have foreseen.

For decades, Fannie and Freddie had used their implicit government guarantee to get huge and powerful. But they got huge and powerful in a pretty boring way. They dealt mostly with standard, 30-year, fixed-rate loans. Borrowers had to document their employment and income, and most made a down payment of 10 to 20 percent.

But then, in the mid-2000s, subprime lenders came on the scene, making loans to people with no income and no jobs.

This kind of easy money made going through all the work to get a Fannie or Freddie loan unappealing for many borrowers, according to Barry Zigas, who was an executive at Fannie Mae during this time.

Imagine a customer going through the lengthy process of qualifying for a Fannie Mae loan, scraping together a down payment, showing up at the bank office, with all the requisite documents in tow.

"And they walk out and in the parking lot is a broker saying, 'Would you like a home loan? Cause let's sit down right here in my car.... We'll do the paperwork right now.' Which was literally what was happening," Zigas says. "And as a consequence, the Fannie Mae share of the market in mortgage backed securities dropped."

We now know that the subprime broker in the parking lot was a sign that we were in the midst of the largest housing bubble in national history.

But at the time, folks at Fannie and Freddie had no idea what was going on. These subprime companies that had been around for just a couple years, that had no government guarantee, were stealing Fannie and Freddie's customers.

And this is the point where the hybrid nature of Fannie and Freddie came back to haunt them. Because, remember, they had private shareholders. And those private shareholders were not happy with Fannie and Freddie's falling market share.

So, after much hand-wringing and internal soul-searching, Fannie and Freddie decided they would follow the subprime industry into the abyss. Fannie and Freddie started accepting lower credit scores, stopped requiring proof of income from all borrowers, and invested in securities made up of subprime loans.

It was "total corporate delusion," says journalist Bethany McLean. "It wasn't actually until really the summer of 2008, when everybody kind of realized the obvious, which was: The mortgage market is falling apart. Fannie and Freddie are the biggest players in the mortgage market. Oh my goodness, what are we going to do?"

In fact, the end came to Fannie and Freddie so swiftly that it caught even their own employees by surprise.

In the late summer of 2008, Jacob Kosoff, a junior-level analyst at Freddie Mac, was feeling confident enough to go on a multi-week honeymoon to Peru.

One day during the trip, Kosoff was hiking the Inca Trail with his new wife and wearing a t-shirt that said, "Freddie Mac, we make home possible." Someone walked by and said, "Oh, Freddie Mac. I heard you guys went out of business."

As Kosoff recalls now, "Random people I don't know, are telling me that my firm, which I had left two weeks ago to go on vacation, no longer existed."

In the fall of 2008, these companies that had grown enormous by trading on the belief that the government would bail them out, finally got what they'd promised. Fannie and Freddie were on the hook for trillions of dollars all over the world — to foreign governments, huge pension funds, a good chunk of the world's banking system.

The implicit government guarantee had become a self-fulfilling prophecy. Fannie and Freddie used the belief that they were too big to fail to actually become too big to fail. And so, just as decades of critics had predicted, just as Fannie and Freddie themselves had secretly promised, the U.S. government came in and bailed them out.

This is part two in our three-part series on Fannie Mae and Freddie Mac. Read part one, "Kill Them, Bury Them," and part three, "What's Next?"

Copyright 2014 NPR. To see more, visit http://www.npr.org/.

Transcript

MELISSA BLOCK, host:

From NPR News, this is ALL THINGS CONSIDERED. I'm Melissa Block.

MICHELE NORRIS, host:

And I'm Michele Norris.

Today, congressional Republicans introduced legislation that would reform Fannie Mae and Freddie Mac, the two mortgage giants taken over by the government in 2008. All this week, our Planet Money team is partnering with journalists Bethany McLean and Joe Nocera, authors of the book "All the Devils are Here." It's for a special series on Fannie Mae and Freddie Mac.

BLOCK: Yesterday, Alex Blumberg explained that the companies were created by the government with a public mission but they were private companies whose owners and managers made enormous sums of money.

And because of their hybrid nature, there was a belief that if they ever got into trouble, the government would bail them out. This implicit guarantee, as it was called, gave Fannie and Freddie huge business advantages but ultimately contributed to their downfall.

Again, here's Alex Blumberg.

ALEX BLUMBERG: By the early 2000s, almost 50 percent of all the mortgages in America were made through Fannie Mae and Freddie Mac. The companies had achieved this dominance because of this implicit government guarantee. Because the rest of the world believed the government stood behind them, Fannie and Freddie paid less to borrow money than almost any other financial institution in the country, which gave them a big advantage.

But even though the government guarantee had turned Fannie and Freddie into two of the largest and most powerful companies in U.S. history, everywhere you turned people denied its existence. At the top of every security that Fannie and Freddie issued, right there in big black letters, it said: This security is not backed by the U.S. government. High-powered government officials denied it, from George Bush's former Treasury secretary, John Snow, to the powerful Democratic congressman Barney Frank. Here he is in September 2003. (Soundbite of archived audio)

Representative BARNEY FRANK (Democrat, Massachusetts): There is no guarantee. There's no explicit guarantee. There's no implicit guarantee. There's no wink-and-nod guarantee. Invest and you're on your own. Nobody who invests in them should come looking to me for a nickel and - nor anybody else in the federal government.

Adding to the course of denial, says journalist Joe Nocera, were Fannie and Freddie themselves.

Mr. JOE NOCERA (Co-author, "All the Devils are Here"): They would adamantly lash back at anybody who argued that there was in fact a government subsidy.

BLUMBERG: That's what they said in public anyway. But to the people who mattered - the ones who were buying Fannie and Freddie securities - the companies said something else entirely.

Scott Simon was one of those buyers. He heads the mortgage department at Pimco, the world's largest bond manager, and one of the biggest buyers of Fannie and Freddie securities.

Mr. SCOTT SIMON (Mortgage Department, Pimco): Fannie and Freddie in meetings with investors, whether it was us or anybody else, essentially just would sort of laugh and say, well, you know the government will stand behind us.

BLUMBERG: They would literally say that you as investors?

Mr. SIMON: I think they said that to most investors. You know, they would sort of wink and nod and just sort of say something along the lines of, well, you know the government can't let us go.

BLUMBERG: Truer words were never secretly spoken. But when the bailout finally did happen, it happened in a way almost no one could have foreseen.

For decades, Fannie and Freddie had used their implicit government guarantee to get huge and powerful but in a pretty boring way. They dealt mostly with 30-year, fixed-rate loans, borrowers had to document their employment and their income, and most of them made a down payment of 10 to 20 percent. But then, in the mid-2000s, subprime lenders came on the scene, making loans to people with no income and no job.

Barry Zigas was an executive at Fannie Mae during this time, and he says imagine a customer going through the lengthy process of qualifying for a Fannie Mae loan, scraping together a down payment, showing up at the bank office, with all the requisite documents in tow...

Mr. BARRY ZIGAS (Former Executive, Fannie Mae): And they walk out and in the parking lot is a broker saying, would you like a home loan? Because let's sit down right here in my car, I'll get that. We'll do the paperwork right now, which is literally what was happening. And as a consequence, the Fannie Mae share of the market in mortgage-backed securities dropped from, I think it was a combined 70 percent at the beginning of the century down to, like, 30-some-odd percent.

BLUMBERG: We now know that subprime broker in the parking lot was a symptom, a sign that we were in the midst of the largest housing bubble in national history.

But at the time, folks at Fannie and Freddie had no idea what was going on. All of the sudden, these subprime companies that had been around for just a couple years, that had no government guarantee, are stealing Fannie and Freddie's customers. And this is the point where their hybrid nature came back to haunt them. Because, remember, they had private shareholders.

And, says Barry Zigas, those private shareholders were not happy with Fannie and Freddie's market decline - and they let the leadership know.

Mr. ZIGAS: And it put a tremendous amount of pressure on management.

BLUMBERG: Do you think that pressure led them to make the wrong decision?

Mr. ZIGAS: Well, in retrospect it's obvious it was the wrong decision.

BLUMBERG: That decision specifically, after much hand-wringing and soul-searching, Fannie and Freddie decided they would not standby but follow the subprime industry into the abyss. Fannie and Freddie started accepting lower credit scores, stopped requiring proof of income in all cases, and invested in securities made up of subprime loans.

Still, they didn't follow them all the way down. Their loans never got as risky as a lot of subprime loans did, and so they thought they were being safe. Journalist Bethany McLean.

Ms. BETHANY MCLEAN (Co-author, "All the Devils are Here"): Total corporate self-delusion. By the time the market starts to crack in the summer of 2007, you'd think Fannie and Freddie would've looked in the mirror and said, oh my goodness; the U.S. mortgage market is falling apart. We're the biggest players in this market. We're in trouble. But they didn't.

Instead, they thought, well, we've only done the safe business and we're going to be just fine and this is our opportunity to shine.

BLUMBERG: In fact, the end came to Fannie and Freddie so swiftly it caught even their own employees by surprise.

Jacob Kosoff was a junior-level analyst at Freddie Mac, and he says that throughout the summer of 2008, despite all the turmoil in the housing industry he wasn't that worried. In fact, in late summer of that year, he was feeling good enough to go on a multi-week honeymoon to Peru.

Mr. JACOB KOSOFF (Former Analyst, Freddie Mac): I was hiking the Inca Trail with my wife and another couple, a Dutch couple, had walked by us and I was wearing my Freddie Mac, we-make-home-possible T-shirt as I was hiking. And another couple walked by and they said, oh, Freddie Mac. I heard you guys went out of business. Random people I don't know are telling me that my firm, which I had just left two weeks ago to go on vacation, no longer existed.

(Soundbite of archived newscast)

Unidentified Man: Breaking news: the markets are reacting to the big news on Fannie Mae and Freddie Mac as the government steps in. Let's get you...

BLUMBERG: In the fall of 2008, these companies that had grown enormous by trading on the belief that the government would bail them out, finally got what they'd promised. Fannie and Freddie were on the hook for trillions of dollars all over the world - to foreign governments, huge pension funds, a good chunk of the world's banking system.

(Soundbite of archived newscast)

Unidentified Woman #1: Treasury Secretary Hank Paulson said today the stakes were too big not to act.

Secretary HANK PAULSON (Treasury Department): Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil here at home and around the globe.

BLUMBERG: And so, just as decades of critics had predicted, just as Fannie and Freddie themselves had secretly promised, the U.S. government came in and bailed them out.

(Soundbite of archived newscast)

Unidentified Woman #2: It is the largest-ever takeover of a financial institution by the federal government in American history.

BLUMBERG: Coming up tomorrow: We own them, now what? The future of Fannie and Freddie now that they're run entirely by the U.S. government and what that means for the American housing market.

For NPR News, I'm Alex Blumberg.

BLOCK: And to hear yesterday's story, visit our Planet Money website, NPR.org/Money.

(Soundbite of music) Transcript provided by NPR, Copyright NPR.

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