Fannie, Freddie and Uncle

Federal Reserve Board Chairman Ben Bernanke recently said there should be closer regulation of Fannie Mae and Freddie Mac because of the widespread but inaccurate public perception that these two companies are backed by the federal government.

A story in Tuesday’s New York Times, unfolding some of the backstory of the mortgage crisis, helps to explain why Bernanke felt the need to say that. It left me with the impression that the federal government effectively DOES back Fannie and Freddie, thought it might not think so.

Fannie Mae and Freddie Mac are nicknames for two companies that were both created by the federal government, whose names begin with the word “Federal.” One was created to provide competition for the other. But they are public companies with stock traded on the New York Stock Exchange, with no formal connection to the government because regulatory oversight.

Together they make up most of the “secondary mortgage market,” in which mortgages sold by others are purchased by Fannie or Freddie, packaged into securities and resold to investors. Other financial houses work in this market but Fannie and Freddie are the 500-pound gorillas in this space, and they were always viewed as safer because they only back “conforming loans,” which exclude subprimes and other exotics.

The risk assessment officer of one of the companies went on the record with the newspaper, saying he repeatedly warned the CEO that risk was growing and it was time to become more prudent. The CEO wouldn’t do it, apparently, based on his own subsequent statements, because he was under a lot of pressure from Congress and his shareholders to buy more mortgages. Congress wanted more Americans to be able to buy a home. Shareholders wanted more profit.

It is clear that the top executives of Fannie and Freddie eventually decided to bend to this pressure because it would be a problem only if there was a broad downturn in home values — which of course is what happened — and in the event of such a calamity as that, the federal government would have no choice but to bail them out — which is happening now.

One of the lead executives, having bent to this pressure, made a big deal of not bending to pressure from Ben Bernanke, who, the New York Times reports, phoned him to say that if he didn’t pull in his horns and show some prudence he, the Benster, would feel obliged to rebuke him publicly.

So Fannie and Freddie sailed full speed ahead into the mortgage default cacastorm.

And, as it turned out, in a sense, investors who think Fannie and Freddie are backed by the government are NOT wrong – they are federally backed in the same way Lehman Brothers turned out to be federally backed — because they are “too big to fail.”