2005: What would happen if Freddie Mac and Fannie Mae are regulated differently?
AUDIENCE MEMBER: Good morning. My name’s Mike Nolan. I’m here from Montclair, New Jersey with my 18-year-old son Brian, who’s experiencing his first Berkshire annual meeting.
My question, and you touched on it a little bit in a couple of earlier questions, deals with the current regulatory environment in Washington, which appears to be growing much more negative on Fannie Mae, Freddie Mac, Farmer Mac, and so forth.
What might the implications for the U.S. consumer specifically, and the U.S. economy generally, be if the GSEs are effectively bridled or significantly restricted from their past charters?
Could this prick what you earlier referred, and some private economists are calling, a real estate bubble and what will be the fallout?
WARREN BUFFETT: Yeah. The GSEs, in effect, expanded their original charter and reason for being.
The thought, originally, was that they would guarantee mortgages and they had this very limited, I think, two-and-a-quarter billion dollar line of credit from the Treasury.
But they were they were brought in, to an extent, to do what FHA and VA had done for mortgages in their arena, was to give people confidence in borrowing money — or in lending money — far away from their own geographical location.
I mean, when the local — when I borrowed money on my house in 19 — bought it 1958 — I mean, I went down to see Mr. Brownlee (PH) at the Occidental Building and Loan, and he, you know, he knew something about me, and he knew something about my parents, and he knew where the house was and all of that.
But as the mortgage market became more institutionalized and it became more — the source of funds became geographically far more distant from the user of the funds, in order to have a market in which — which would be efficient, the GSEs were a very logical development.
And the GSEs came in, Freddie and Fannie, and the idea was that for a fee, which used to average about 25 basis points, they would guarantee these mortgages so somebody living 3000 miles away could buy them through securities and not worry about the individual property.
And then, the portfolio operations developed over the following years and, of course, they enabled the GSEs to earn high rates of return on capital, because, in effect, the GSEs were looked at as government guaranteed so that people would lend them money without worrying about the degree of leverage employed.
And, in effect, the GSEs became huge — they hugely developed what might be called the carry trade, using the government’s credit, in effect, and the spread between what they paid on their money and what they got on mortgages.
So that became the dominant source of their earnings. They got very carried away with delivering promised rates of growth.
I remember reading in the Freddie Mac report some years ago, where they talked about delivering in the mid-teens or low-teens or something like that.
And I thought to myself, you know, that this is madness, because you can’t do that when you’re running a big carry trade operation. Interest rate — the slope of the curve will develop.
There’s no way to lend money for 30 years to somebody who can pay you off 30 seconds later, to actually match assets and liabilities in a way that’s risk-free.
The only way you could do it would be to issue a 30-year bond of your own, which you could call 30 seconds later, and people don’t buy those bonds.
So, as a practical matter, you could not perfectly handle the risk of significant interest rate changes.
But the GSEs got caught up with delivering increasing earnings all the time to Wall Street.
So they first enlarged their portfolios and later, as we’ve seen, they got involved in some accounting shenanigans, which really sort of boggle the mind when you think of two of the most important institutions in the country, with all kinds of financial experts on the board and top-named auditors and everything, and turning out that billions and billions and billions of dollars were misreported.
It shows you what can happen in a system.
Now Congress is reacting, administration is reacting, [Federal Reserve Chairman] Alan Greenspan is reacting, in terms of saying that, you know, what have we created?
What is this — the situation where these two companies have a trillion-and-a half or more of mortgages they own, and people really think the federal government is on the hook, and the federal government does — wants to say it isn’t on the hook.
But the truth is, it is on the hook. And institutions worldwide own the credit — own the securities — based on this implied promise. And it was all being done just because, basically, these companies wanted earnings per share to go up.
Now, they say they did it to maintain an orderly market, and all that stuff, in the mortgages. But they were really set up to guarantee mortgage credit.
And there’s going to be reaction in Congress. It will be a huge fight.
Both of those institutions have been heavy supporters of various legislators over the years. They’ve got lots of clout. Not as much clout as they had a year ago, but they’ve got lots of clout in Congress.
And on the other hand, people have lost faith, to some degree, in what they’ve done.
And they’ve also seen that the consequences of the government issuing a blank check to two institutions that are trying to produce annual gains in earnings per share of 15 percent, and doing it by accounting means when they ran out of the ability to do it by other means.
So it’s something that Congress should be giving a lot of attention to. They can’t cut them off, in my view and, I think, most people’s view. They can’t say get rid of your portfolios or anything like that.
So my guess is that some kind of a curtailment comes in, some kind of tougher accounting requirements come in, sometimes it may be tougher capital ratios. And that over a long period of time, the government tries to figure out something that sort of eases them out of this position, where they were basically backing two entities that, at times, acted like the two biggest hedge funds in history.
Charlie?
CHARLIE MUNGER: Yeah. Well, he was asking, partly, is what happens if the government reins these two institutions in and forces a big reduction in asset base.
WARREN BUFFETT: I don’t think they’ll — I don’t think the government is going to do something worse, they sell off hundreds of billions of dollars of mortgages, at all.
But if they curtail it — let’s just say they say that from now on you got to operate in a runoff mode for a few years. There are plenty of people out there to buy mortgages.
They’re already buying the securities of Fannie Mae and Freddie that are financing the mortgages. So it isn’t like Fannie and Freddie, independently, were coming up with the funds to finance these mortgages.
They got them from somebody else and that somebody else can leave Freddie and Fannie out of the picture and buy the mortgages through some other form.
It would not be the end of the world, at all, if Freddie and Fannie no longer had new portfolio purchases. I don’t think it would change things in any significant way, in terms of the cost of homeownership or anything else.
How about you, Charlie?
CHARLIE MUNGER: Well, I agree. I don’t think it would have enormous macro effects if future growth were curtailed.
I do think a lot of the troubles that came, came from a large use of derivative books, and from Fannie and Freddie both believing a lot of silver-tongue salesmanship from derivative traders.
And, as many of you know, I think there is much wrong with derivative accounting and derivative trading operations in the United States, and I don’t think the full penalties have yet been paid.
WARREN BUFFETT: When you can have a $5 billion mismark in one direction at one of these — and bear in mind these are among the most scrutinized companies in the world, and with outstanding people on their boards, in terms of financial expertise — if you can have a $5 billion mismark in one direction, while at the same time the other one has a 9 billion mismark in the other direction, you know, I would say we’ve come a long way from Jimmy Stewart and “It’s a Wonderful Life.” (Laughs)
CHARLIE MUNGER: Yeah.