Fannie and Freddie Flipped: A Backwards Induction Analysis of the GSEs' Meltdowns

Charles J. Abrams, Law Student, Florida State University College of Law

Abstract

The unprecedented growth, eventual take-over of half the mortgage market and ultimate failure of Fannie Mae and Freddie Mac stems from the decision-making strategies of the companies’ managers. Using a three-period backwards-induction analysis, this article first explores the history and unilateral benefits the government conferred upon the two government-sponsored enterprises (GSEs), and then explains, through the lens of opportunistic managers, why and how Fannie and Freddie engaged in systemically risky activity that ensured their bailouts. I show that although both the decisions and methods of the GSEs' expansions were fraught with moral hazard problems and created a giant burden on taxpayers, the managers acted in a logical manner to maximize shareholder wealth while simultaneously mitigating risk. Therefore, the blame for the GSEs rests on the United States' economic policies covering homeownership, which lacked the appropriate mechanisms to monitor and measure the potential harm of Fannie and Freddie. The article concludes with an overview of the Dodd-Frank Act and its ability to prevent future managers from engaging in this sort of opportunistic behavior.