The Crisis of 2007-2008: A Turning Point in the Evolution of Government-Sponsored Mortgage Finance

The Crisis of 2007-2008: A Turning Point in the Evolution of Government-Sponsored Mortgage Finance

Overview

In the mid-20th century, the United States government created a system of mortgage finance that aimed to promote homeownership and stability in the property market. However, by the early 21st century, this system had become increasingly unstable, ultimately contributing to the financial crisis of 2007-2008. At its center was Fannie Mae, a government-sponsored enterprise (GSE) established in 1938 as part of President Franklin D. Roosevelt’s New Deal programs.

Context

The United States experienced significant economic growth and urbanization following World War II, leading to an increasing demand for housing and mortgage finance. To meet this need, the federal government established the Federal Housing Administration (FHA) and the Veterans Administration (VA), which provided insurance guarantees for mortgages to low-income families and veterans. These programs were later supplemented by Fannie Mae and Freddie Mac, two GSEs that securitized mortgages and sold them on the open market.

Government-sponsored enterprises (GSEs) played a critical role in this system, as they allowed banks to offload mortgage risk while earning returns through the sale of mortgage-backed securities. Over time, however, the proportion of government-backed mortgages decreased, while the share held by Fannie Mae and Freddie Mac increased.

Timeline

• 1938: President Franklin D. Roosevelt establishes Fannie Mae as a GSE.
• 1955: The proportion of non-farm mortgages underwritten by the federal government reaches its peak at 35%.
• 1970s-1980s: The US economy experiences inflation and high interest rates, leading to increased defaults on government-backed mortgages.
• 1990s-2000s: Fannie Mae and Freddie Mac become increasingly dominant in mortgage finance, with their share of the market growing from 4% to 43% between 1955 and 2003.
• 2003: The Office of Federal Housing Enterprise Oversight (OFHEO) relaxes capital requirements for GSEs like Fannie Mae and Freddie Mac.
• 2007-2008: The US housing market begins to decline, leading to a crisis in the mortgage finance system.

Key Terms and Concepts

Government-sponsored enterprise (GSE)

A GSE is a private company that receives explicit or implicit government backing to provide financial services. Fannie Mae and Freddie Mac are examples of GSEs involved in mortgage finance.

Mortgage-backed securities (MBS)

MBS are debt securities collateralized by mortgages. They allow banks to offload mortgage risk while earning returns through the sale of these securities.

Risk-based capital requirements

Risk-based capital requirements refer to regulations that dictate how much capital a financial institution must hold in relation to its assets and level of risk exposure.

Subprime lending

Subprime lending involves providing credit to borrowers who do not meet traditional underwriting standards. This type of lending is often associated with higher levels of default and delinquency.

Key Figures and Groups

Fannie Mae

Founded in 1938, Fannie Mae was initially a government agency responsible for purchasing and securitizing mortgages. In 1968, it became a private corporation with a congressional charter to provide liquidity to the mortgage market.

Freddie Mac

Established in 1970, Freddie Mac is another GSE that provides financing for residential mortgages. Like Fannie Mae, it was initially a government agency but later became a private company.

Mechanisms and Processes

The following diagram illustrates the flow of funds through the mortgage finance system:

             +---------------+
             |  Banks        |
             +---------------+
                     |
                     | (originate)
                     v
             +---------------+
             |  GSEs         |
             |  (Fannie Mae,  |
             |   Freddie Mac)  |
             +---------------+
                     |
                     | (securitize)
                     v
             +---------------+
             |  Investors    |
             |  (buy MBS)     |
             +---------------+

Deep Background

The rise of Fannie Mae and Freddie Mac in the mid-20th century was closely tied to changes in the broader economic and regulatory environment. The post-war period saw rapid growth in housing demand, which led to an increase in mortgage lending. However, this growth also created new challenges for lenders, who faced rising defaults and delinquencies.

To address these issues, policymakers introduced various regulations and reforms aimed at stabilizing the mortgage market. These included the creation of GSEs like Fannie Mae and Freddie Mac, which allowed banks to offload mortgage risk while earning returns through the sale of MBS.

Explanation and Importance

The crisis of 2007-2008 was ultimately caused by a combination of factors, including:

• The growth of subprime lending and the proliferation of securitized mortgages.
• The relaxation of capital requirements for GSEs like Fannie Mae and Freddie Mac.
• The failure of regulators to address issues related to risk-based capital requirements.

This crisis had significant consequences for the US economy, leading to widespread job losses, home foreclosures, and a sharp contraction in economic activity. In the aftermath of the crisis, policymakers introduced various reforms aimed at strengthening financial regulation and reducing systemic risk.

Comparative Insight

The rise of Fannie Mae and Freddie Mac shares similarities with other government-sponsored enterprises, such as the UK’s National Loans Fund or the Canadian Mortgage and Housing Corporation. These institutions have all played critical roles in providing financing for housing markets, but their experiences also highlight the importance of careful regulation and oversight.

Extended Analysis

The Evolution of Government-Sponsored Enterprises

Fannie Mae and Freddie Mac were not the only GSEs involved in mortgage finance. Other notable examples include:

• The Federal National Mortgage Association (FNMA), which was established in 1938 but later privatized.
• The Government National Mortgage Association (GNMA), which provides guarantees for mortgages insured by the FHA.

The Impact of Regulatory Reforms

The crisis of 2007-2008 led to significant changes in financial regulation, including:

• The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
• The introduction of stricter capital requirements for banks and other financial institutions.

Open Thinking Questions

• What role do government-sponsored enterprises play in promoting homeownership and stability in the housing market? • How did changes in regulatory policies contribute to the crisis of 2007-2008? • What are the long-term implications of the reforms introduced in response to this crisis?

Conclusion

The crisis of 2007-2008 was a turning point in the evolution of government-sponsored mortgage finance. Fannie Mae and Freddie Mac, once hailed as champions of homeownership and stability, ultimately became symbols of regulatory failure and market instability. As policymakers continue to grapple with the challenges of housing finance, they would do well to draw lessons from this experience and prioritize careful regulation, oversight, and transparency.