Subprime Mortgage Crisis Part Two

We all remember the subprime mortgage crisis, right? Well, here we go again. At least it’s a possibility according to William Poole, senior fellow at the Cato Institute and former CEO of the Federal Reserve Bank of St. Louis. In an op-ed published by CNN, Poole argues that the Federal Open Market Committee (FOMC), a branch of the Federal Reserve that determines the direction of monetary policy, could be ignoring some of the same factors that led to the unfortunate bailout of Bear Sterns nine years ago.

In 2008, FOMC apparently failed to even read Fannie Mae and Freddie Mac’s 2007 annual report. A little reading would have uncovered that Fannie Mae and Freddie Mac were insolvent toward the end of 2007. A rather serious oversight considering that those two entities (organized as “Government Sponsored Enterprises” or “GSEs,”) were the principal house lenders responsible for the creation of much of the subprime mortgages.  Bear Stearn’s problem, like many others, came from excessive investment in bonds based on those same subprime mortgages.

Unfortunately, it appears that the Fed is again repeating that same oversight mistake, underestimating GSEs for their likely contribution to instability in the housing market. Look no further than to Freddie Mac’s 2016 annual report, where one of its top priorities for 2017 includes expanding access to affordable mortgage credit. To make matters worse, Fannie Mae and Freddie Mac redefined the credit threshold for what credit rating is considered subprime. Before the crisis, a credit rating of 660. Now? 620. Simply put, GSEs may be buying even weaker mortgages than before the financial crisis. Those weaker mortgages are then wrapped into mortgage-backed securities that GSEs sell to the market. Fannie May and Freddie Mac back these securities, and the government backs Fannie Mae and Freddie Mac. You can see where this goes.

Besides an eerie feeling of déjà vu, one phrase comes to mind. Those who do not learn history are doomed to repeat it. So what is the outlook for today? The Fed has accumulated a significant number of Fannie Mae and Freddie Mac bonds. Many experts believe that retaining those bonds would trigger larger risks for future inflation. Freddie Mac’s 2016 annual report suggests that 36% of its obligations are tied to mortgage insurance used for weaker mortgages in event of default. I could go on and on. Poole at least gives us one positive: Less private capital is at risk if there is another subprime mortgage crisis. While the underlying issues still linger, that is one bit of good news for all of us consumers out there.