JOURNAL - A SHORT HISTORY OF BANKING

Financing the American Dream


2019/04/29 - Monocle Journal

In August 2013, President Barack Obama visited the Desert Vista High School in Phoenix, Arizona. It was around five years after the housing market collapsed in the US, with Phoenix being right at the centre of the devastation when the bubble burst. Addressing a crowd of thousands that had gathered at the school, the president spoke about an idea many thought had died during the 2007/2008 financial crisis – the American Dream. “The most tangible cornerstone that lies at the heart of the American Dream, at the heart of middleclass life,” he said, “that’s the chance to own your own home.” The crowd roared. The white-picket-fence American Dream was still alive and well in the collective consciousness of the people.

American Dream

In the history of America, and indeed much of the Western world, the notion of home-ownership goes far beyond the physical purchase of a house – it is at the very core of modern Western culture. From John Locke’s famous Second Treatise (1660) advocating the God-given right to private property, to the Founding Fathers of America, the idea of property ownership is deeply engrained in our thinking, with Thomas Jefferson declaring that “a right to property is founded in our natural wants.” Thus, it seems, without the deeply-rooted desire to own a home, the very idea of the American Dream would make very little sense.

In recent decades, this sentiment has persisted, endorsed from the heights of political power. Before Obama, George W. Bush was a fervent proponent of an “ownership society”, promoting the values of personal responsibility, economic liberty, and critically, the ownership of property. During his two terms, President Bush heavily pushed policies that were in line with the core principles of the ownership society ideology. “Thanks to our policies,” Bush said in his acceptance speech to the Republican National Convention in 2004, “home ownership in America is at an all-time high. Tonight, we set a new goal: seven million more affordable homes in the next ten years so more American families will be able to open the door and say, ‘Welcome to my home.’”

Before George W. Bush, President Clinton too pushed the idea of “a home for every American.” During his presidency from 1993 to 2001, Clinton revamped the Community Reinvestment Act (CRA) created by Ronald Reagan in 1977, promulgating it via the Housing and Urban Development (HUD) department to encourage banks to provide credit to struggling middle- to low-income communities. To enforce the Act, regulators would assess whether banks had taken on the required portion of “credit-deprived” clients onto their books, with compliant institutions being favoured for approval for new branch applications, as well as merger and acquisition requests. For these low-income applicants – dubbed “subprime” borrowers due to their tarnished or limited credit histories – to afford their repayments, banks had to radically decrease the initial deposits on these loans, with down payments dropping from around the traditional 20% to 3% in 1995, and to zero in 2000. These loans were, however, often accompanied by adjustable interest rate terms that increased repayment amounts as the loan matured, making it progressively more difficult for borrowers to fulfil their payments as time went on.

To expand the home-ownership rate even further, Clinton ordered the government-backed mortgage buyers Fannie Mae and Freddie Mac to increase their portfolio of these subprime loans to 40% in 1996, and eventually reaching 55% in 2007 under the order of George W. Bush. This government mandated increase in the approval of “subprime” mortgages has led many economists to infer that the seeds of the 2007/2008 financial crisis were sown during the Clinton era, exacerbated under Bush, and facilitated by the government-backed institutions of Fannie Mae and Freddie Mac – perhaps the two single least-understood companies in American economic history.

The Federal National Mortgage Association (FNMA), or Fannie Mae, was founded during the Great Depression in 1938, as part of President Roosevelt’s New Deal. Fannie Mae’s purpose was to expand the secondary mortgage market by buying home loans from banks, effectively taking those loans off banks’ balance sheets to create liquidity for the banks to make more loans. During the Great Depression, creating liquidity was a major concern for government, as severe economic conditions had made it almost impossible for the public to get access to credit, with banks being unwilling or unable to create more loans in those uncertain times. Decades later, the government created the Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac. Its purpose was to serve as healthy competition for Fannie Mae and to extend further the secondary mortgage market under the direction of the Emergency Home Finance Act of 1970 – an emergency measure put in place after significant political pressure called for the diversification of the secondary mortgage market, which at the time only had one major player, Fannie Mae. And whilst both Fannie and Freddie are government-created institutions, with the backing of tax payers’ money as government-sponsored enterprises (GSEs), they are still publicly-traded companies with profit-driving CEOs, who earn many millions of dollars a year in individual compensation. And whilst it is not explicitly stated, these GSEs, for all intents and purposes, have the implicit guarantee of government bailout in the event of bankruptcy. 

During the 1990s and early 2000s, business was booming for Fannie Mae and Freddie Mac. They were consistently the most profitable companies in the Fortune 500 list and CEOs such as Frank Raines – son of a janitor, chairman of Fannie Mae from 1999 to 2004, and listed in Time’s “25 People to Blame for the Financial Crisis” – received $90 million in salary and bonuses whilst he was head of the GSE. This was also the time, however, during which Fannie Mae, steered by Raines and instructed by government, was rapidly increasing the acquisition of middle- and low-income mortgages, prompting The New York Times to report in 1999 that it is “taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidised corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

When the subprime mortgage market collapsed in 2007, Fannie Mae and Freddie Mac held more than half of America’s home loans in securities, with half of those being riskier HUD-mandated loans and a significant portion being subprime in nature. The Washington Post estimated that between them, the two giant GSEs had purchased around $434 billion in securities backed by subprime loans. And by July 2008, with their stocks plunging and their capital rapidly running out, the government’s implicit guarantee of bailout had become a stark reality. With half of the United States’ $12 trillion mortgage market at risk, there was little choice for the government but to take Fannie Mae and Freddie Mac into curatorship on 7 September 2008. Since their forced curatorship in 2008 and delisting from the New York Stock Exchange in 2010 – with Fannie Mae’s shares trading below $1 for more than a month, as opposed to over $60 in the years leading up to 2008 – the bailout of Fannie Mae and Freddie Mac has cost US taxpayers upwards of $187 billion. This is on par with AIG’s eventual cost to taxpayers of $182 billion and amounts to more than the entire rescue plan for the Savings and Loans Crisis, costing the nation just shy of $132 billion at the time.

Despite the obvious shortcomings of government policy leading up to the 2007/2008 financial crises and the retrospectively-imprudent actions of the two government-sponsored enterprises, many argue that Fannie Mae and Freddie Mac are not entirely to blame for the crisis – even relegating them to minor participants in the overall mess – although few can deny that they played at least a supporting role in the dramatic demise of the housing market. One such apologist was Nobel laureate economist Paul Krugman, who all but excused Fannie Mae and Freddie Mac from blame. Krugman believes that it was primarily the shadow banking system that caused the collapse of the US housing market, with little wrongdoing attributed to Fannie Mae and Freddie Mac. Yet many experts have argued that the government-backed mortgage buyers, in fact, facilitated the growth of the shadow banking sector, by steadily taking on ever more risky assets, in the form of hundreds of thousands of low-income and subprime loans.

In 2019, Fannie Mae and Freddie Mac are still under curatorship, with the directive to pay the United States Treasury annual dividends, which have to date resulted in the return of $59 billion in 2013 and $134 billion in 2014 from Fannie Mae alone, ultimately covering the $187 billion recovery package they had received. As it stands, there is significant political pressure to remove these two GSE behemoths from state curatorship, as well as revoking their status as government-backed and government-controlled institutions in the future. What these economists, including Krugman, fail to address in their arguments, however, is that it is fundamentally engrained in the idea of the American Dream that every family has the right to own a home.

For centuries, political-economic rhetoric in the US has revolved around the idea of “a home for every American”. And to facilitate this ideology, giant government-backed institutions were created, dating back to the days of the Great Depression. The problem with these institutions, as has been demonstrated, is that while they are capitalist in nature, acting as free-market agents, they can essentially take indefinite risk, as they are provided the security of a taxpayer bailout if they were to eventually fail. And despite their contradictory nature, as essentially both private and public entities, their existence is politically expedient to every president – whether Democrat or Republican – as their purpose ties in so neatly with the right of owning a home, which the American Dream promises, as opposed to the responsibility that comes with this privilege.



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