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After the late 1980s thrift crisis, during which savings and loans that made mortgage loans throughout the United States went bankrupt, the government took a more aggressive role in the U.S. housing market. A network of Federal Home Loan Banks makes low-cost loans to banks and financial institutions so that they can lend money to mortgage borrowers. The Federal Housing Administration, FHA, part of the United States Department of Housing and Urban Development, or HUD, insures mortgage loans made by FHA approved lenders. These FHA loans are then sold to GNMA (or Ginnie Mae) a government agency that packages (securitizes) the loans for investors. Ginnie Mae “packages,” known as agency passthroughs (they pass through interest and principal payments to investors), are backed by the full faith and credit of the U.S. government, meaning U.S. taxpayers. Fannie Mae (FNMA) and Freddie Mac (FHLMC) were privately chartered United States mortgage giants regulated by HUD. While Fannie and Freddie were private and their securitizations were not guaranteed, the overall sense was that they were (1) too big to fail; and (2) had the implied moral obligation of the U.S. government (that would be you, the taxpayer). Freddie Mac and Fannie Mae are now so huge that many believed a default by either of them would cause a crisis of confidence and the global markets would collapse—they are too big to fail. Too big to fail means American taxpayers will pay for a bailout. It turns out this thinking was correct. In September 2008, both Fannie Mae and Freddie Mac were placed in conservatorship. A new regulator, the Federal Housing Finance Agency (FHFA) fired (and replaced) the CEOs, fired the former boards of directors, and took control in a form of nationalization. With so much at stake—meaning U.S. government funds obtained from taxpayer dollars—one would think that HUD, the FHA, Fannie Mae, Freddie Mac, and the 12 Federal Home Loan banks (plus the army of regulators that oversee them) would make sure that the lending is prudent, because if it is not, the U.S. government will have to pay. Sadly, that has not been the case, perhaps because the government feels it is dealing with other people’s money—the money of the U.S. taxpayer. Mortgage lending practices in the United States are tightening up, but there is still a long way to go to get back to prudent lending. As for the new regulator, it is headed by James B. Lockhart, who also oversaw the old regulator (the Office of Federal Housing Enterprise Oversight or OFHEO). It seems to me that the new sheriff looks a lot like the old sheriff.

Fannie Mae and Freddie Mac purchase mortgage loans from mortgage lenders and earn fees for guaranteeing payments on other mortgage loans.To prevent losses, Fannie Mae and Freddie Mac have requirements for the types of loans they will buy. But, they came under pressure to relax those standards, and their risk increased as a result. Fannie Mae and Freddie Mac package up these loans and create securitizations known as conventional passthroughs. Some mortgage lenders cannot keep going if Fannie Mae and Freddie Mac refuse to buy their mortgage loans. In this way, Fannie Mae and Freddie Mac are indirect mortgage lenders.

Fannie Mae and Freddie Mac are highly leveraged, and they were extremely vulnerable to failure. If you are highly leveraged, you must keep the quality of the mortgage loans very high, because a small decrease in value is amplified by leverage. But if you have it in the back of your mind that you can have a colossal screw-up and someone will bail you out, it almost guarantees you will make lousy financial decisions. It is a crazy way for any investor to think. It is the antithesis of Benjamin Graham’s philosophy. Warren told me that, as an investor, everyone makes mistakes, but you don’t have to do a lot right as long as you avoid big mistakes.

Fannie Mae and Freddie Mac appeared to be careful back in the day. Loans had to “conform” by meeting lending guidelines so the borrower had