Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Followup Information from Dwight Jaffee, Haas School of Business, University of California at Berkeley

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Monday, June 14,2010

Phil AngeJides

Chairlllal1

Via E-mail and FedEx
Professor Dwight Jaffee
Haas School of Business
545 Student Services # 1900
University of California at Berkeley
Berkeley, CA 94720-1900
iaffee@haas.berkeley.edu

Hon. Bill Thomas

Vice /mirtlmn

Re:

Follow-up to the Financial Crisis Inquiry Commission Forum

Dear Dr. Jaffee:
Brooksley Born

COllllllissioner
Byron S. Georgiou

Comlllissioner
Senator Bob Graham

Commissioner
Keith Hennessey

The Financial Crisis Inquiry Commission thanks you once again for your
participation in the "Forum to Explore the Causes of the Financial Crisis" on
February 26 and 27,2010.
Enclosed are follow-up questions which were posed by the Commissioners
during the forum, as well as additional questions which have arisen over the
course of our investigation which we would like your assistance in answering.
Please respond to the questions by Friday, July 2, 2010. If you have any
questions, or would like more information, please contact Scott Ganz at
sganz@fcic.gov.

Com III issioner
Douglas Holtz-Eakin

Commissioner
Heather H. Murren, CFA

Commissioner
John W. Thompson

Commissioner
Peter J. WaIIison

Commissiol1er

1. Please comment on the following excerpt from a statement by former
Federal Reserve Chairman Greenspan to the Commission on April 7, 2010:
"Of far greater importance to the surge in demand, the major U.S.
government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, pressed
by the U.S. Department of Housing and Urban Development1 and the Congress to
expand "affordable housing commitments," chose to meet them in a wholesale
fashion by investing heavily in subprime mortgage-backed securities. The firms
purchased an estimated 40% of all private-label subprime mortgage securities
(almost all adjustable rate), newly purchased, and retained on investors' balance
sheets during 2003 and 2004. That was an estimated five times their share of
newly purchased and retained in 2002, implying that a significant proportion of
the increased demand for subprime mortgage backed securities during the years
2003-2004 was effectively politically mandated, and hence driven by highly
inelastic demand. The enormous size of purchases by the GSEs in 2003-2004 was
not revealed until Fannie Mae in September 2009 reclassified a large part of its
securities portfolio of prime mortgages as subprime.
"To purchase these mortgage-backed securities, Fannie and Freddie paid
whatever price was necessary to reach their affordable housing goals. The effect

Wendy Edelberg

Executive Director

1717 Pennsylvania Avenue, NW, Suite 800 • Washington, DC 20006-4614
202.292.2799 • 202.632.1604 Fax

was to preempt 40% of the market upfront, leaving the remaining 60% to fill other domestic and
foreign investor demand. Mortgage yields fell relative to 10-year Treasury notes, exacerbating
the house price rise which, in those years, was driven by interest rates on long-term mortgages."
(footnotes omitted)
2. Please discuss the relationship of the GSEs' purchase of Alt-A mortgages and Alt-A mortgagerelated private-label securities to their affordable housing goal requirements.
3. The United States has gone through other periods, e.g., with respect to FHA subsidized mortgage
programs in the late 1960s, when credit was so freely available to low income borrowers that low
underwriting standards led to large numbers of defaults and foreclosures. Please discuss the
dynamics of such circumstances and the extent that there are relevant lessons for the current
financial crisis.
4. During the forum, you described a paper prepared for Lyndon Johnson regarding the GSEs. Can
you provide us a copy of the paper?
Sincerely,

Wendy Edelberg

July 20, 2010
Wendy Edelberg
Executive Director
Financial Crisis Inquiry Commission
Dear Wendy:
I am responding to your letter and questions of June 14.
1) Comment on excerpt from statement by former Chairman Greenspan on April 7, 2010
Chairman Greenspan states three “facts” in the except you provided:
1) That Fannie Mae and Freddie Mac purchased large amounts of subprime mortgages;
2) That the Fannie Mae and Freddie Mac purchases were not revealed until September 2009; and
3) That the Fannie Mae and Freddie Mac purchases were motivated significantly by HUD.
I agree fully with the spirit of points (1) and (2). My own testimony before the Commission documented
the enormous purchases of subprime mortgages by Fannie Mae and Freddie Mac. I thought that the GSEs
had revealed these purchases a bit earlier than September 2009; but they certainly postponed revealing that
information until long after the purchases.
I do not agree with point (3)--also discussed in my own testimony. The GSEs revealed a desire for
risk-taking wherever it could be found. Earlier, they took on huge amounts of interest rate risk. It was only
the good fortune of generally stable interest rates that saved the GSEs from an even earlier failure from an
interest rate shock. At my testimony, we also discussed another motives for the GSE foray into subprime
mortgages, namely to recover the market share than had been lost to the private-market securitizers.
In summary, I would say that the GSE motivation to purchase subprime mortgages had a variety of
motives, all of which pointed in the same direction: (1) increase expected profits through risk-taking; (2)
recovery of lost market share; and (3) to satisfy the HUD housing goals. When we have limited data and
three indicators point in the same direction, empirical data cannot select among them. I continue to believe
that the incentive to maximize expected profits through risk-taking has been the consistent pattern in GSE
behavior for at least at the last 20 years.

2) I do not have any technical or expert knowledge on the actual relationship between the GSE purchases
of Alt-A mortgage securities and the Affordable Housing Goals. I will say, however:
(i) ALT-A refers to mortgages that were “alternative to the GSE normal underwriting standards”. It is thus
peculiar to find the GSEs purchasing mortgages that were explicitly contrary to their normal standards.
(ii) HUD has always maintained that the affordable housing goals were never meant to lead to a
deterioration in the GSE underwriting standards.
3) I am unaware that FHA subsidized programs “led to a large number of defaults and foreclosures” in the
late 1960s. I am glad to say that was before my time! We have to be sure we are discussing the same
programs. My testimony, to the extent it touched on the FHA, concerning only their single-family
mortgage guarantees. By law, these programs provide no subsidies. Or to be even more precise, if the
programs do provide a subsidy, they must obtain an explicit Congressional appropriation. Almost always,
they provide no guarantee and require no appropriation. HUD and the FHA, of course, run a myriad of
programs, including multi-family programs, that do provide subsidies, and, I recall, did create
defaults—although I think those were mainly due to fraud. Nether fraud nor default have characterized the
non-subsidized, single-family, mortgage guarantee programs.
4) The paper that discusses the creation of the first GSE—Fannie Mae in 1968—was written by my Ph.D.
student here at Berkeley, Sarah Quinn. The paper was also quoted in a NY Times article about the GSEs.
Her entire thesis will soon be available. In the meantime, I am attaching her paper. To give you the
executive summary: The Presidential Commission that created Fannie Mae was well aware of the
possibility that a private firm with a public mission might try to maximize profits at the taxpayers’ expense
and reported this concern to the President. President Johnson, apparently, had no patience for these
concerns: he had a Vietnam War to fight and a budget to balance, and privatizing Fannie Mae was a means
to that end.

Things of Shreds and Patches:
Credit Aid, the Budget, and Securitization in America

Working Paper1
Revised as of September 2009

Sarah Quinn
Ph.D. Candidate
Department of Sociology
University of California, Berkeley

1

This paper is drawn from my dissertation, which investigates the role of politics in the establishment of a market for
securitization in the U.S. Selections from this paper were presented at the All-UC Group on Economic History (May 12, 2009),
and it has benefited from the comments of discussant Larry Neal and conference participants, and at the Annual Meeting of the
American Sociology Association (August 9, 2009). Suggestions are most welcome and should be forwarded to
squinn@berkeley.edu.

ABSTRACT
Federal credit programs issue, purchase, insure, and guarantee loans. As the U.S. government
accumulated assets through these programs in the postwar era, it began to sell them, sometimes
using the proceeds to offset budget deficits. As early as the 1950s government agencies used putoptions, guarantees, and pooling techniques to encourage these kinds of sales; in the 1960s
President Lyndon B. Johnson expanded these practices in hopes of offsetting the large deficits
caused by the Vietnam War and his Great Society Programs. When a budget committee’s change
of accounting standards thwarted this plan, his administration was forced to find an alternative.
The one they devised would transform American housing finance. The administration
immediately spun-off Fannie Mae, which removed the agency from the budget. It simultaneously
devised a plan to get private capital to take the place of government funds in the secondary
mortgage market, using a version of its own controversial debt instruments to do so. That is, the
government set out to build a viable private market for Mortgage-Backed Securities (MBS), and
provided an array of supports for it. Tracing these events, this paper examines how government
efforts to circumvent the budget contributed to the rise of securitization in the U.S. This suggests
that the relationship between the U.S. government and its markets may be more profoundly
organized by the institution of the federal budget (and less driven by a laissez-faire ideology)
than is suggested by the current literature.

Modern policy-makers’ ingenuity . . . has created mechanisms for
spending unknown in past ages; and extensive use of such devices has
made modern budgets into things of shreds and patches.
Carolyn Webber and Aaron Wildavsky, 1986

In a number of cases, the Federal credit programs have pioneered in
developing new credit fields.
House Committee on Banking and Currency, Federal Credit Programs,
1964

The Housing and Urban Development Act of 1968 was a turning point in American
housing finance. It quietly dismantled the system of direct government mortgage purchases that
was established in the New Deal to encourage lending. In its place, the Act laid the foundation
for a new kind of secondary mortgage market organized around the privatized Fannie Mae and
bonds backed by pools of mortgages called Mortgage-Backed Securities (MBS). Carruthers and
Stinchcombe (1999) have argued that the sustained efforts of the U.S. government were integral
to the creation of a liquid secondary mortgage market in the states. The Housing and Urban
Development Act of 1968 was a key part of that effort.
We know a great deal about the problems in housing finance behind these events. The
most fundamental issue is the unwieldy nature of mortgages as investments. The value of each
mortgage depends on its unique location, property and owner, and this lack of standardization
raises information costs and risks. For these reasons many investors historically dismissed
mortgages as more trouble than they were worth. This created funding shortages for mortgage

Shreds and Patches | 1

lenders, shortages that worsened as pension and mutual fund managers controlled more and more
capital that they refused to invest in housing finance. Since the New Deal the U.S. government
had stepped in to provide support through an array of programs that included insurance for
mortgages and the direct purchase of those insured mortgages.
This system of credit support, in place since the 1930s, was strained by the 1960s (Green
and Wachter 2005; Sellon and VanNahmen 1988). Reliance on local Mortgage Banks and
Savings and Loans in housing finance had resulted in an inefficient patchwork of markets across
the nation (Sellon and VanNahmen 1988). Reserves of capital were locked up in accounts on the
East Coast, leaving homebuilders in the rapidly-developing Sunbelt starved for credit. Some
worried that the system could not accommodate the growing needs of the baby boomers as they
settled down and had children (Ranieri 1996). These endemic problems were further exacerbated
by inflation-driven disintermediation. In 1966 yields on U.S. Treasury bills rose above 4 percent
for the first time in over 20 years and funds poured out of local accounts (Green and Wachter
2005). The subsequent credit crunch in housing caused the biggest dip in home building in 20
years (Fish 1979; Green and Wachter 2005). Facing a worsening set of credit shortages and a
budget already strained by the Vietnam War and the Great Society programs, the Johnson
Administration decided to support private investment in mortgages, hoping the market would
better meet America’s housing needs. The government encouraged the use of securitization2 in
order to advance that market.

2

Sometimes the term securitization is broadly used to denote the creation of any bond backed by some kind of collateral (as with
the German Pfandbrief developed in the 18th century). For this paper I adopt the more narrow definition of securitization used in
the American housing literature, wherein securitization specifically refers to cases in which the collateralizing assets are removed
from the issuers’ balance sheets.

Shreds and Patches | 2

In most accounts of these events, budgetary politics are either absent or else discussed
briefly as an exogenous pressure that comes into play only at the close of the 1960s. But my
research indicates that the federal budget had a more extensive influence on America’s MBS.
This project puts budgetary politics at the center of this history. Below I present a brief overview
of federal credit aid programs in the U.S. through the close of the 1960s and then consider the
peculiar relationship these programs had with the Federal budget. I next examine how the
combination of direct loan programs and budgetary pressures led to experiments with asset sales
and debt instruments in the postwar era.
In reviewing this history, I seek to better understand the forces that contributed to the
ascendance of securitization in the U.S. On a general level, I explore how federal credit lending
set the stage for MBS by advancing the development of credit techniques and markets, by
generating a large pool of federal loans ready for the taking, and by helping governmental
officials gain expertise in the management of loans. More specifically, this paper argues that
President Johnson’s securitization-friendly policies culminated from years of experiments with
credit lending and debt instruments which officials pursued in order to find a politically
expedient way of intervening in markets without adding to the public debt. Connecting the
history of credit lending with the creation of MBS, I argue that budgetary politics played an
important role in the rise of securitization in America.

This effort is grounded in a growing body of scholarship that shows that the myth of
American free markets is belied by a reality of enduring and widespread state intervention in the
economy (see, for example, Block 2008; Krippner 2007, Popp Berman forthcoming; Tobey

Shreds and Patches | 3

1996). This flawed notion of laissez-faire America persists because of the peculiar form its state
intervention typically takes. Many have observed a pattern wherein the U.S. government has
sought to camouflage, hide, or understate the extent to which it actually intervened in the
economy. David Moss argues that risk management policies in general owe some of their success
to their ability “to reconcile [American’s] laissez-faire and anti-statist sentiments with their
pragmatic inclination to employ state power to solve social problems” (2002: 319). He further
notes that policies designed to spread risk “may have proved particularly appealing in the United
States because they tended to require little in the way of invasive bureaucracy and could easily
be cast in the rhetoric of contract” (2002: 320). That is, Americans seem to like governmental
interventions better when they are dressed up like the market. Along similar lines, Fred Block
(2008) has identified a “hidden developmental state” behind a host of industrial and
technological inventions, and Greta Krippner (Krippner 2001), examining monetary policy under
Regan, identifies a “Neoliberal Dilemma,” in which officials hide the extent of their marketmanaging policies in order to escape political responsibility for their actions.
Time and again, the U.S. government has veiled its market interventions by seeking to
blend in with the market around it, masking its incursions using a kind of market camouflage.
Securitization is another example of this pattern. And it is an especially useful example, because
it points to how the federal budget may be a key institution that compels this strategy.
I begin, below, with a broad overview of federal credit programs because they offer a
window into how and why this dynamic plays out. I argue that these programs are remarkable in
the ways that they facilitated financial innovation throughout the postwar era. Designed to be an

Shreds and Patches | 4

inexpensive way of governing the economy, these programs came to target virtually every sector
of the U.S. economy in the postwar era. In the process, they helped transform American finance.

Federal Credit Lending
Government regulation of the American economy traces back to colonial times (Novak
1996) and risk management is one of the most important and enduring strands of these efforts. In
his historical investigation of state risk management programs, David Moss (2002) argues that
across a wide variety of markets, businessmen have at times found themselves incapable of
managing the tangle of risks that threaten markets. 3 The government is uniquely positioned to
manage risks, however, because it can use its “power to compel”4 participation in programs to
more easily reallocate and redistribute risks as needed. So when private brains historically failed
to devise independent solutions for risk management, the state stepped in. In his history of
American risk management programs, Moss shows that risk management is one of the major, if
most often overlooked, functions of the U.S. government, evident in interventions ranging from
minting money and setting limited liability law, to overseeing social security and product safety.
While government risk management covers a broad range of activities, this paper
addresses a subset of those efforts: federal credit aid, or programs that issue, guarantee, insure,
and buy and sell loans. These programs sometimes inject capital directly into markets, and at
other times encourage lending by allowing the government’s credit to stand in for the borrowers’

3

These risks include moral hazards, adverse selection, limited information, as well as problems with perception, commitment and
externalization (Moss 2002).
4

Or “the legitimate use of force,” to recast this in Weberian terms. Weber, Max, Hans Heinrich Gerth, and C. Wright Mills. 1946.
From Max Weber: Essays in sociology. New York,: Oxford university press.

Shreds and Patches | 5

credit. In both cases, the government encourages lending by bearing the risk of a default on a
loan. A government report on the state of federal credit lending explains:
. . . a Federal credit program arises when the Federal Government enters
into the credit economy by interposing its own credit for that of various
types of borrowers. . . Irrespective of the source of funding, the ultimate
credit risk of any of these programs is borne by the Federal Government,
even though as a practical matter, actual credit losses will, in most cases,
be covered out of reserves for bad loans accumulated out of interest
income or insurance premiums (House 1964: 17).

The above cited 1964 Federal Credit Report, commissioned by the House Banking and
Finance Committee, is useful both as a snapshot of federal credit programs in the years leading
up to President Johnson’s transformation of housing finance and as a broader overview of the
history of federal credit aid. Based on a survey of all government agencies in 1964, it offers a
unique window into the growth of these programs in the postwar era. Before the Second World
War, credit programs relied mainly on direct loans (see Table 1). After World War II, the use of
guarantees and insurance overtook direct lending as the predominate mode of credit support,
largely due to the expansion of housing insurance through the FHA and VA (see Figures 1 and 2).
Throughout both periods the scope of credit assistance widened, but housing and agriculture
remained the primary focus of support. In all, the report paints the picture of a set of programs
that proliferated and became more complex over time. Even a limited look at the details of that
history shines a light on the importance of federal programs in the development of American
credit markets.
While the government had earlier forays into lending, the creation of the Federal Land
Bank System in 1916 marked the beginning of the systematic use of credit aid in America
(House 1964). Over the next decade, fifteen additional programs were created to support key
Shreds and Patches | 6

sectors like war finance, railroads, interstate commerce, and agriculture. The Depression spurred
an influx of funds into existing programs and introduced a new generation of credit aid that
included guarantees and insurance. In 1932 the Reconstruction Finance Corporation (RFC) was
created to lend to financial institutions and railroads. Within the decade it grew into a financial
behemoth that issued loans to states and local governments, purchased stocks and mortgages, and
incubated other key lending agencies like the Federal National Mortgage Corporation (Fannie
Mae) and the Commodity Credit Corporation (CCC).
The system of federal credit supports that would bolster homeownership throughout the
20th century was also built at this time. The government took multiple steps to stem a “wave of
foreclosures” to the amount of 250,000 homes a year during the depression (Green and Wachter
2005: 94-95). Home Owners Loan Corporation (1933) was created as a stopgap for further
foreclosures, and a year later the Federal Housing Administration (FHA) was chartered to insure
mortgages and so encourage lending. The Federal Home Loan Bank System, designed like the
Federal Reserve System, offered credit support to Savings and Loans (1932), while Fannie Mae
(1938) further encouraged the use of FHA-insured loans by agreeing to purchase them. The
Works Administration started the first loans for public housing programs in this period as well.
The development of the agricultural sector was another special focus of credit programs.
A variety of approaches were used to support the nation’s struggling farmers. In addition to the
Federal Farm Mortgagee Corporation (1932) and Banks for Cooperatives (1933), which provided
financial support to farmers, the Rural Electrification Administration used credit supports to help
bring electricity to the 89% of farms that were without it in 1936. Like housing, agriculture
would remain a central focus of credit aid as the federal programs developed.

Shreds and Patches | 7

Credit support was not limited to housing and agriculture. Direct lending was used to
support employment efforts, often through the backing of state and local projects. In 1934 the
Export-Import Bank was created to support the economy by lending money abroad for the
purchase of American commodities. During World War II the growth of federal direct lending
slowed. Still, “V-loans” guaranteed by the Defense Department were initiated to promote
wartime production and credit assistance, especially for housing and agriculture. After the War
the Veterans' Administration (VA) guaranteed home, farm, and business loans to veterans. The
VA, along with the FHA, was behind a dramatic rise in the use of guarantees and insurance
following the war. In the Depression years of 1932-36, the government issued a combined $14.3
billion in direct loans, and guaranteed just under a $1billion of loans. In the years following the
war (1947-50) $16 billion of direct loans were issued, a relatively modest rise in comparison to
the use of guarantees, which shot up to $19.5 billion (see Table 1).
When the House surveyed federal credit agencies in 1963, they found that the
government contained 74 separate credit aid programs in its agencies, 51 of which issued loans
directly. At the time, the government held $30 billion in assets and insured or guaranteed another
$70 billion, three quarters of which derived from the FHA and VA (House 1964, PCBC 1967).5
Commenting on the scope of federal credit aid, the committee noted, “the credit programs
extended to every segment of the American economy—financial institutions, agriculture,
business, private housing, State and local government, international trade, and individual
households” (House 1964: 5).

5

The report on Federal Credit Programs (House 1964) generally excluded non-recourse loans out of the Commodity Credit
Corporation, and non-commercial foreign loans (like those out of A.I.D.) from calculations, since those programs were
effectively grants and more like direct expenditures than a form of credit support.

Shreds and Patches | 8

By the 1960s federal credit aid had evolved into a sprawling, decentralized web of
programs that offered a mix of guarantees, insurance, and loans. Jurisdictional overlaps
sometimes led to competition among agencies and this complex system allowed for variation and
flexibility that fostered innovations in the management of credit lending. For example, each
agency used its own accounting methods to determine its own reserves. At one extreme were five
programs without any reserves; at the other was the FHA, which calculated reserves that
assumed a depression-level crisis (House 1964). Some programs were capped by monetary
ceilings or number of grants, but fifteen agencies had no statutory limits, among them the FHA
and VA. Some programs were funded through appropriations, others through the Treasury or
capital markets (see Figure 5). Within the subgroup of direct loans programs, the type of support
offered varied widely, from non-recourse loan programs at the Commodity Credit Corporation
that were unlikely to ever be repaid, to non-commercial loans like those at A.I.D. ($12 billion of
issued by 1967) where the likelihood of default was unknown, to more traditional commercial
loans at the Export-Import Bank and Fannie Mae (House 1964). Even the less exotic commercial
loans contained a wide array of terms. For example, loans to low-income people and businesses
were subsidized in a variety of ways, “with longer maturities, smaller down payments, or lower
interest rates than are generally available otherwise” (Budget 1965: 305).
Perhaps the most important legacy of these programs was their ability to change the rules
of the game in credit markets, expanding notions of how a company could lend money, and to

Shreds and Patches | 9

whom.6 The congressional report on Federal Credit Programs explains that they helped
individual borrowers build credit histories and expanded lenders’ willingness to accept new kinds
of borrowers, loans and risks:
From the viewpoint of the borrower, this private financing provides him
with an opportunity to show the private lender that he is capable of
administering borrowed funds and thereby helps to build a good credit
record. In the future this credit reputation could enhance the possibility of
his obtaining private loans at interest rates and other terms that are
generally reserved for the better credit risks. . . . From the viewpoint of
the lender, these credits serve to acquaint it with the financial attributes of
borrowers or of types of loans to which heretofore it has not been
accustomed. Familiarity coupled with a favorable loan experience might,
in time, induce such lenders to make similar type loans on favorable terms,
perhaps without reliance on Federal participation or insurance. . . .
Furthermore, Federal credit administration also involves working with
private lenders to induce them to alter their requirements or to change their
concepts in order to participate in loans being made or insured by the
Federal credit agency. (House 1964: 86)
In addition to this, many lending techniques we now take for granted owe their success to
government programs: “Over the years the Federal credit agencies have pioneered a number of
financial practices which were subsequently adopted by private lenders. Longer repayment
periods, higher loan-to-value ratios, and the use of amortized repayments” (House 1964: 70).
One example of governmental leadership can be found with mortgages on existing homes
purchased in the postwar era, where FHA and VA insured loans led the conventional loans with
longer maturities and larger loan-to-value ratios (see Table 2) (Carter, Gartner, Haines, Olmstead,
Sutch, Wright, and Snowden 2006). Conventional loans in 1950 had a median maturity of twelve
6

Figures 3 and 4 chart the growth of Federal credit aid in the mortgage market. Please note, however, that the actual extent of the
financial impact of these programs is much debated. For a more in-depth consideration of these debates as they pertain to housing
finance, see Quigley 2006. Some scholars warn that it is easy to overstate the extent to which government credit programs have
actually helped homeowners, insisting that they came to crowd out private investors who otherwise would have entered the
market. Others argue that by bringing new homeowners into the lower end of the market, these programs benefited many
homeowners who did not directly receive credit aid. Quigley himself concludes that these programs played a big role in
developing housing markets, and now have increasingly small effects. Quigley, John M. 2006. "Federal Credit and Insurance
Programs: Housing." Federal Reserve Bank of St. Louis Review 88:281-309.

Shreds and Patches | 10

years and a Loan-To-Value (hereafter LTV) ratio of 64%. In the same year, a government
guaranteed mortgage had an average maturity that was nearly twice as long (20 years), with
substantially higher average LTV ratios: 76% at FHA and 86% at the VA. By 1964, when the
Federal report was published, conventional loans looked liked the FHA guaranteed loans issued
fourteen years earlier, with a median maturity of 20 years and a LTV of 76%. By that time, the
government guaranteed loans had even looser terms, with an average maturity of nearly 30 years,
and LTVs of over 90%.
These programs profoundly shaped the terrain of American credit markets, and also
generated expertise that government officials could use to address budget conflicts. Officials
could also exploit the complexity of this sphere when budget problems forced them to face
difficult trade-offs, as I discuss below.

Credit Lending and the Budget
Federal credit programs were not just blazing new paths in the field of credit. They were
also at the forefront of efforts to manipulate the budget. According to Webber and Wildavsky
(1986), the drive to achieve a balanced budget is a hallmark of early American Exceptionalism.
As a result politicians have faced tremendous pressures to solve problems without spending
money or by hiding the extent of their expenditures. The use of earmarking and special funds
have long been used to get around the budget process (Webber and Wildavsky 1986). But
Webber and Wildavsky note that the 1960s introduced of a new set of strategies that undermined
the comprehensive reporting of public spending in governmental budgets in a variety of
countries. They classified these strategies into four general types: tax deductions that forgo
Shreds and Patches | 11

revenues, entitlements that fall outside of annual controls, loan guarantees and pledges of credit,
and the creation of quasi-public “off-budget” corporations. “When all of these developments are
looked at together,” they wrote, “the movement away from comprehensiveness is seen as a
stampede” (Webber and Wildavsky 1986: 601).
Federal credit programs were a key part of this trend towards off balance sheet
accounting in postwar America. Solutions were often selected on the basis of what had the least
impact on the budget:

Fiscal considerations, i.e. impact on the Federal budget and on the public
debt, heavily influence the decision as to whether Federal credit assistance
is to be financed through Treasury-financed direct loans, market-financed
direct loans, or Federal loan guarantees. Efforts to circumvent the budget
and the public debt through the use of market-financed direct loans or
Federal loan guarantees result in increased interest costs. (House 1964;
Stark 1964, in House 1964)
That budgetary politics seemed to trump the nation’s credit needs, or what was the least
expensive option in the long-run, was a major concern among regulators.
The relative impact of various types of credit aid on the public debt varies. Guarantees
and insurance programs contributed the least to the deficit; this helped make them extremely
popular. They generated enough in fees and premiums to cover their operating expenses and
would only show up on the budget if the Treasury got involved to cover absorbed losses in
excess of held reserves. The extra political value derived from their off-budget status likely
contributed to the rapid growth of these programs; from 1961 and 1966 alone, their liabilities
shot up by 75% (Budget 1965).
The budgetary ramifications of the direct loan programs were more complicated. In the
long run the programs were very efficient. They brought in revenues, which gave them a low net
Shreds and Patches | 12

cost, and many programs were able to use collections and fees to cover operating expenses. 7 But
in years when the government issued a great deal of loans, disbursements ran ahead of
collections and repayments and the net difference would typically be reported as expenditures on
the budget.8 Even though these programs would eventually generate funds, their immediate
budgetary impact could put them in danger of being cut. This created an incentive to fund loan
programs through the capital markets. Perhaps the most well-known way of doing this was
through the creation of semi-private government corporations. In 1963, for example, five
agencies had the authority to issue their own debt: the Federal Land Banks, Federal Intermediate
Credit Banks, Banks for Cooperatives, Federal Home Loan Banks, and the Secondary Market
Operations at Fannie Mae. Since they were financed through the capital markets, the agencies
were classified as private corporations that did not have to be included in the administrative
budget. Since the agencies had to pay more than the Treasury to borrow funds, this approach
saved political capital at expense of economic capital.
Other agencies experimented with drawing funds from capital markets as well. Since the
Depression, the RFC had supplemented its direct loan program with “participation loans,” which
allowed banks to issue or own part of a much larger loan. RFC also developed a “deferred
participation” program, wherein a private lender issued loans on the condition that the
government would agree to purchase a portion of the loan at a later date if the lending company

7

The Special Analysis of the Budget in 1963 explains, “Unlike almost all Government programs the initial expenditures involved
for credit programs are largely or wholly repayable, so that the ultimate net cost is normally low. Some programs are full selfsupporting; in most others, the income from interest payments or insurance and guarantee fees covers most of the current
expenses and/or provides reserves for future losses.” (Special Analysis, 1963: 305)
8

In 1964, about half of the 74 credit programs were able to use revolving funds that allowed them to recycle their revenues back
into their programs (see Figure 5), but I do not know how many of these were specifically direct loan programs. From the FCP:
“Direct loans have a major budgetary impact since the difference between disbursements and repayments represents net
expenditure or receipts. Federal guarantees and insurance of private loans, on the other hand, ordinarily have only minor effect on
Federal expenditures, since they result primarily in expenditures by private financial institutions.” (Special Analysis, 1963: 307)

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wanted to sell it.9 In other words, the RFC used put options to encourage private lending.
Participations were also used by the Federal Reserve Banks, as well as to advance public
housing, urban renewal, college housing public facility loans and others.
Another strategy was to sell government assets. This would prove to be an especially
flexible tool for managing the budget, because proceeds from the sales were typically counted
like collections and netted against expenditures, lowering the size of the deficit. Seymour Harris
reports that Presidents Truman and Eisenhower both sold off accumulated assets to balance
accounts:

In four fiscal years (I954-57), the Eisenhower administration disposed of
$1,780 million of certain capital assets; in the four preceding years the
Truman Administration had disposed of but $364 million of corresponding
assets. These sales yield cash for the budget, and the income rises
relatively to outlays. But though the budget comes nearer to a balance, the
net effect is no genuine improvement: one capital asset is sold and the
income used to pay off debt or keep debt from rising. (Harris 1956: 359)

Kennedy and Johnson also relied on asset sales to lessen the size of the budget deficit. In 1963
substantial increases of lending from U.S. A.I.D were offset by sales at the Export-Import bank
and the VA; through the use of netting, the government was able to report a relatively modest
$1.8 billion in credit expenditures for the upcoming year, even though they expected $8.1 billion
in disbursements (Tickton 1955). This was typical of the era. With the help of asset sales, the
difference between outlays and reported expenditures for credit programs on the federal budget
widened considerably from 1961 to 1966 (see Figure 6). These sales were mostly done through
9

In more detail: “Three types of loans were made by RFC—direct loans, immediate participation loans, and deferred
participation loans. Direct loans were authorized, disbursed, and serviced by RFC. Immediate participation loans were those
made in cooperation with financial institutions, wherein part of a loan was disbursed by RFC and the balance by the participating
institution, with servicing either by RFC or the participating institutions. Deferred participation loans were disbursed and serviced
by participating institutions with an agreement with RFC under which the Corporation agreed to purchase a stated portion of the
outstanding loan upon the request of the institution making the loan.” (House 1964)

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The Export-Import Bank and Fannie Mae because those agencies had the best, most sellable
loans: “Most of the loans held by other federal credit programs have interest rates, maturities, or
other terms which make them currently unattractive to private lenders except at sacrifice
prices” (Budget 1965: 379).
Selling assets was useful but not always practicable. The federal credit system was made
up of 74 programs and this decentralization meant high transaction costs. Additionally, as we saw
above, selling subsidized loans and loans to people with lower credit was particularly difficult.
As officials sought to expand the sale of loans, they soon discovered that they needed a better
way to sell them. Seeking new ways of tapping capital markets and selling off assets, they began
to experiment with tailoring debt instruments to fit their needs.

The Rise of Participation Certificates
Just as the credit programs had pioneered the use of new credit terms, the government
now pioneered the use of complex debt instruments. They used pools of assets, put-options and
guarantees to construct bonds that held wide appeal and could be more easily sold. That is, the
government pioneered the use of securitization to fund its lending activities. These pool-based
financial structures contained many different features as they developed. They varied by type of
collateral and payment structure and whether they had put-options or carried some kind of
guarantee from the government. But they tended to share a similar relationship to the federal
budget: they were accounted for like other asset sales, which meant that revenues from sales
were used to offset current expenditures.10

10

LBJ Archives, White House Central Files. (FI) EX FI 4-2/1 1968; File: 6/1/67-10/23/67, Memo. “What are Participation
Certificates?”

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To my knowledge, the first sales of pools of government assets happened in the 1930s,
when the CCC sold off asset streams from pools of commodity loans, mainly cotton
(Congressional Budget Office 1978). The RFC was the next government agency to sell bonds

collateralized by pools of loans in 1953. At the time RFC was being disbanded and the
government needed to do something with the over $2 billion worth of assets it held or
administered. Its foreign loans went to the Export Import Bank, its disaster loans went to the
Small Business Administration, and its mortgages went to Fannie Mae (House 1964: 203). 2,848
leftover smaller loans totaling $73.4 million were collected into a “RFC Loan pool,” which
collateralized “certificates of interest” that bore a 3% interest rate.11 These were sold in
September 1953.
A month later the Commodity Credit Corporation used a similar structure to sell
“certificates of interest” that were collateralized by a pool of its loans. This was apparently an
emergency measure taken in order to counter a budget overage of over $1 billion.12 In a white
paper reviewing the changing nature of budgetary concepts, Sydney Tickton (1955) explained
that the pool was poorly structured and the U.S. government ended up repurchasing the loans

11 “On September 28, 1953, the loans and securities portfolio of RFC, net of the assets later transferred (as
described above), amounted to 6,650 loans, securities, and commitments totaling $618.6 million. There were 4,628
direct business loans and commitments outstanding amounting to $395.5 million and RFC was committed, on a
deferred basis, to purchase participating shares in 1,676 business loans for $26.4 million. The outstanding balances
on these loans ranged from under $100 to $48.4 million. To dispose of the smaller business loans in its portfolio
RFC with the cooperation of a committee of commercial bankers appointed by the American Bankers Association
and the Association of Reserve City Bankers established an "RFC Loan Pool." For this pool 2,848 loans, with
individual balances outstanding, except for 2, under $500,000 and aggregating $73.4 million outstanding, were
selected. To obtain immediate cash on these loans, the "pool" sold certificates of interest, bearing interest at the rate
of 3% percent per annum to nearly 1,000 banks and private investors. The certificates, each representing an
undivided share of the pool loans, totaled $47 2 million and were retired by July 5, 1956, out of repayment of the
pool loans. In effect, the certificates of interest arrangement gave the participants a 3%-percent return on short-term
loans, collateralized to the extent of 156 percent by loan assets whose repayment was reasonably assured. In
December 1953 the Treasury 90-day bill rate was 1.63 percent; the interest rate on 9-12 month Treasury obligations
was 1.61 percent; and the interest rate on 3-5 year Treasury obligations was 2.20 percent.” (House 1964: 203)
12

Tickton 1955, filed in the National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of
Budget Review, Budget Methods Branch, 1952-1969.

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from investors the next year for $1.5 billion. Despite this failure, agencies continued to
experiment with these new debt instruments.
In 1962 the Export Import Bank adapted the use of the pooling technique, this time
selling “Participation Certificates”13 backed by the pools. In this case pooling was useful because
the Bank did not have to release the names of the countries whose loans were being sold off. This
anonymity allowed both the U.S. government and those countries to avoid potential political
embarrassment from the sale. 14 Two years later the Omnibus Housing Act of 1964 authorized
Fannie Mae to sell off participations in $300 million in mortgages. As the Wall Street Journal
reported, this “concentrated the benefit” of repayments on those loans into 1964 and offset $300
million of spending in 1964 (Jessen 1964).
As costs of the Vietnam War and Great Society programs pushed the budget towards the
debt ceiling, the Johnson administration moved to massively expand the use of participation
certificates with the Participation Sales Act of 1966.15 Johnson saw lending programs as a key
element of his Great Society agenda. A governmental staff paper later commented on this,
It is clear that the Executive Branch of the Government considers the
Participation Sales Act as a tremendous breakthrough in financial
management of Federal lending programs. It is also clear to many that
Federal lending will be an increasingly important vehicle for the
expression of public priorities in coming years. . . .
Financing of Federal lending programs by direct Treasury debt issuance,
of course, means financing under the public debt limit. Financing by the
issuance of agency issues is outside of the debt limit. Therefore, in
13

National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget Review, Budget
Methods Branch, 1952-1969, File: Participation Certificates – 1962-65 Letter from Christopher Weeks March 26, 1962 on the
Export-Import Bank Participation Certificate Sale.
14

Tickton 1955, c.f. National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget
Review, Budget Methods Branch, 1952-1969, Box 31.
15

See also Congressional Budget Office, U. S. (1978). Loan Guarantees: Current Concerns and Alternatives for Control: A
Compilation of Staff Working Papers. C. B. Office. Washington: xv, 58 p.

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addition to the obvious desirability of having a business-type enterprise
stand on its own feet by doing its own borrowing, a further incentive is
given to a preference for agency borrowing as a way to get around the debt
limit when that limit is pinching the treasury rather badly.16

Thus it is possible that Johnson fully grasped the potential of finance as a means of intervention
into the market, one that would allow him to assert his priorities while avoiding congressional
accountability.
In its original form, the Participation Sales Act would have authorized Fannie Mae to sell
$33 billion in loans held throughout the U.S. government. Facing fierce resistance from
Republicans, the final version of the bill allowed Fannie to broker only $11 billion worth of loans
from six agencies. At the center of the debate about the Participation Sales Act was concern over
how to account for them in the Federal Budget. Part of the problem was that the PCs had a
guarantee of payment of principal and interest from the government. This meant that in the last
instance the Treasury would be on the hook if something went wrong with these deals. Some
looked at this arrangement and asked: If the government processed the loans and retained their
risks, then had it really sold the assets? And if this wasn’t a real sale – if the Treasury was really
on the hook just as it was for other government bonds – then wasn’t this just another way of
raising money? By this logic, the government hadn’t reduced expenditures at all. It had done the
opposite – it had issued a new kind of debt. Instead of spending less, it owed more.
First in committee and later on the floor, Republicans rallied against participation sales.
Many longstanding debates about how to best finance and account for credit programs found

16 National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget Review, Budget
Methods Branch, 1952-1969. Box 120. BOB Comments on PCBC Report – Chapter V. May 29, 1967 Staff Paper (Memo to the
President’s Commission Budgetary Concepts.) Loans, Participation Certificates, and the Financing of Budget Deficits. See pp 12
and 15.

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voice in their objections. Republicans branded this a dangerous budgetary gimmick designed to
“camouflage” the full extent of the Administrations spending. As a kind of “backdoor”
accounting that bypassed appropriations, it concentrated power in the hands of the President. The
sales were thought to render the budget ceiling toothless and the deficit meaningless. In a
statement of his individual view, Rep. Paul Fino articulated how private capital could be used to
manipulate public accounts. “Like all ‘crisis economics’ proposals,” he said, “this scheme
blends economic shakiness with political opportunism.”

The real reason for private capital being desired is that while Treasury
borrowing would be of no budget camouflage assistance, private funds
obtained through pool participation sales refinancing can be chalked up on
the plus side of the budget ledger.
Under the guide of “recruiting” private capital to share the burden of
Government capital, the administration is offering a program the real
thrust of which, in budget deficit years, the extent of the budget deficit can
be camouflaged by receipts gained from a sale of Government assets for
private funds. I hardly need to add that this is a mechanism for economic
and political fraud (House 1966: 33).

Republicans further recycled concerns about the high costs of financing outside of the Treasury.
Since Fannie Mae could not issue debt as cheaply as the Treasury, and since the government
would have to subsidize some of the deals, participation sales meant the government would be
paying a premium to hide the size of the budget: “What really happens though the participation
device is that pooled assets are not sold, they are really refinanced in a more costly way because
Fannie Mae cannot borrow as cheaply as the U.S. Treasury” (House 1966: 18).
Republicans insisted that if this were a true sale of assets they would have supported it,
but that this was not a true sale. They objected that the purchaser would not receive a title to the

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pooled asset or a pro rata interest in the pool, but rather “interest at a rate stated in the
participation certificate” (House 1966: 18). They further noted that “the agency pooling the loan
continues to bear the responsibility and burden of servicing the loans. The agency pooling the
loans remains exposed to the risks of default” (House 1966: 18). Finally, they warned that the
credit protection ran into moral hazard problems: since any bad debts were backed with credit
protection from the government, they would sell at the same price as a good debt.
Publicly Democrats conceded that PCs padded the budget, but they also insisted that the
primary impetus behind the bill was to bring private funds into the market (Congressional
Quarterly 1966). Privately they were sometimes more candid. In a letter to Johnson’s Special
Assistant Barefoot Saunders, Democratic Representative Brock Adams explained, “The deficit is
so bad that many of us who believe that these assets should be used either for emergencies or for
long-term benefits and not to simply cover operating deficits have supported them because of the
emergency caused by the Viet Nam spending.”17
A close look at what happened when it was time for the government to sell participation
certificates in 1967 suggests that for the White House, manipulating the budget took precedence
over drawing private funds into the mortgage market. Recall that rising mortgage rates had
caused a credit crunch in housing in 1966. In response Fannie Mae had purchased over $4 billion
worth of mortgages. Johnson was eager to offset this, even in part. But selling participations in
mortgages would divert funds from private investments, making money even more scarce. The
Treasury sent a memo to the President telling him to avoid issuing PCs until market conditions
changed. Johnson now had to choose between what was best for the housing market and what

17

LBJ Archives, White House Central Files, LE, Legislation, LEF/FI 5-4. October 27, 1966. Letter from Brock Adams to
Barefoot Saunders.

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was best for his budget. In a game of financial chicken, the White House delayed the sale of PCs
hoping for better market conditions to come around. But regardless of what state the market was
in, they would only delay the sale of PCs until the end of 1967 so as make sure the sales could be
counted in the budget.
At this point, the administration worked to reduce the impact of the sale on the housing
market. Johnson and the Treasury had weighed selling all the PCs back to the government, but
rejected this as a possibility because it would cause political embarrassment. Instead they had the
Trusts invest in a smaller portion of the PCs. Contrary to his statements about bringing private
funds into the housing market, in 1967 Johnson released as few PCs onto the market as he could
politically get away with.

The Fall Out and Spin-Off
Johnson won the battle over participation certificates, but it cost him. His credibility gap,
so infamously associated with the Vietnam War, now caused problems with the budget. A staff
paper prepared for a presidential commission to review the budget points to this:
Whether or not the criticism is valid, it may be fairly said that the
treatment of participation certificate sales as a reduction in budget
expenditures and budget deficit, particularly since they have become
sizable in amount, has perhaps done more to undermine public and
congressional confidence in the integrity of budget totals than any single
other issue.18

18 National Archives , RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget Review, Budget
Methods Branch, 1952-1969. BOB Comments on PCBC Report – Chapter V. May 29, 1967 Staff Paper (Memo to the President’s
Commission Budgetary Concepts.) Loans, Participation Certificates, and the Financing of Budget Deficits.

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Early in January of 1967 Henry Fowler, head of the Treasury, sent a memo to the White House
explaining that debates about the budget were increasingly heated and acrimonious, citing the
participation sales act as a “prime example” of this.19 In order to smooth the waters he
recommended the President convene a special committee to review the budget. Fowler argued
that the political advantages of a more transparent budget (and, through that, protection from
accusations of budget gimmickry) outweighed the potential negative of less flexibility. Three
months later the White House announced that it had appointed the President’s Commission on
Budgetary Concepts (PCBC) to make a “thorough study” of the Federal Budget (Concepts 1967:
105). It would be headed by banker David Kennedy, and its members would include the heads of
the Treasury, Bureau of the Budget, and General Accounting Office. The Chair and two minority
members of the Appropriations committee would also serve on the PCBC, alongside a set of
private experts.
The Commission called for a complete overhaul of the federal budget and the creation of
the new “Unified Budget.” Its members reached consensus on everything except participation
certificates. 20 Over the strenuous objections of the Secretary of the Treasury, Henry Fowler, and
the Director of the Bureau of the Budget, Charles Schultze, the Commission concluded that PCs
were not a true sale of assets, which meant they were liabilities:
In one sense, the sale of shares in a pool of loans is but a short, logical
step beyond the sale of the asset itself; but it is a crucial step. When an
asset is sold, the Federal Government retains no equity in it although it
usually guarantees the loans it sells. When it is pooled, however – and
participation certificates sold in the pool – the ownership (though not the
19

National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget Review, Budget
Methods Branch, 1952-1969, File: PCBC – Appointment of Commission Members. Jan – March 1967, Jan 12, 1967. Henry
Fowler. “Memorandum for the President.”
20

LBJ Archives. Administrative Histories Collection. Administrative History of the Bureau of the Budget. The Administrative
History of the Bureau of the Budget, p.29

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beneficial equity) is still retained by the federal government. Interest
payments on the loan continue to flow to the Government and the
Government continues not only to incur servicing costs but also to assume
fully the risk of default on any individual loan as far as the investor in the
participation certificate is concerned (Concepts 1967: 55).
If the government serviced the loans and held the risk, then the government owned those
mortgages. This refuted the logic that ownership inhered in revenues and so could be parsed
from risks and removed from balance sheets. The ruling would not merely prevent PCs from
being used as budgetary reductions; now considered a liability, they would add to the deficit. It
was therefore an expensive political problem for the Johnson Administration. 21
The PCBC’s decision triggered both the privatization of Fannie Mae and the
transformation of participation certificates into mortgage-backed securities. Johnson’s men
recognized that the new accounting treatment meant that Fannie Mae’s secondary market
operations (that is, the part of Fannie Mae that purchased extant mortgages) would become very
difficult to fund if they were listed on the budget without offsets.22 At the same time, they felt
that disregarding the President’s own commission would be a “political impossibility”23 and a
“major tactical mistake.”24 They had to find a new solution to their problem with the budget.
A series of committees about mortgage finance had been meeting since 1966. Headed by
James Duesenberry of the Council of Economic Advisors, who worked closely with Sherman
Maisel of the Federal Reserve, the committees had been working through various options for

21 See, for example, the Administrative History of the Treasury: “This was an extremely difficult issue because of its political
connotations.” (15) Administrative Histories Collection. Administrative History of the Treasury.
22

LBJ Archives. Lapin to Weaver 1/3/67. Subject: Budgetary Treatment of Secondary Market Operations

23

LBJ Archives, White House Central Files, Box 37: EX FI 4-2/1 1968. File FI 5 Credit –Loans 4/21/66 – 9/6/66. March 9,
1968.DeVier Pierson. Memorandum for the President
24

LBJ Archives, White House Central Files, Box 37: EX FI 4-2/1 1968. March 6, 1968. File FI 5 Credit –Loans 4/21/66 –
9/6/66. Memorandum for DeVier Pierson. Subject: Secretary Freeman’s proposal on Budget Concepts.

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reforming housing finance, which included replacing Fannie Mae with a private company as well
as the possibility of creating a long term mortgage-backed bond to replace the participation
certificate. Following the PCBC’s ruling, these committees were given priority.
At this point things moved quickly. In September, a full month before the Commission’s
report was even published, they reconvened as part of a Mortgage Finance Task Force; its
“central proposal” was deemed “the creation of a new bond representing an interest in a bundle
of federally-underwritten mortgages. . . The new bond would be similar to PC’s in concept, but
would work to infuse more money into the mortgage market . . .”25 The new bond they discussed
would become Pass-Through Certificates, which many people consider to be the first modern
MBS. The Senate Housing and Currency Committee would later comment on the potential
usefulness of these new instruments: “if such securities become well enough established so that
many private issuers are issuing them, they could constitute a significant factor in attracting
investment funds to the field of mortgage investment” (Senate 1968: 79).
At the same time as the government moved forward with its plan to develop a market for
a new kind of mortgage bond, the White House began working with the Department of Housing
and Urban Development and the Bureau of the Budget to spin-off Fannie Mae. Fannie Mae
would be split into two organizations. Functions considered essential to the government would
be incorporated into a new government agency, the Government National Mortgage Association,
or Ginnie Mae. This new agency would be authorized to guarantee mortgage-backed securities
issued by approved private companies as long as the mortgages they pooled were already insured
by the FHA or VA. Thus the pools as planned at this point involved two kinds of governmental

25 LBJ Archives. White House Central Files, Federal Government Files, FG 600, Memo to the President from Califano about
MFTF.

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guarantees: (i) the FHA and VA’s insurance of the loans going into the MBS pool, and (ii) a
guarantee from Ginnie Mae of the return of principle and interest. The first guarantee protected
the company issuing the debt in the case that homeowners defaulted; the second guarantee of the
pool itself protected investors if a bank that issued the securitized bonds defaulted (Black,
Garbade, and Silber 1981). Johnson’s men had considered eliminating the second Ginnie Mae
guarantee -- they worried that it could raise the very accounting objections they were working to
solve26 -- but the bankers they consulted insisted that investors would rather buy Treasury
securities and would only invest with some kind of guarantee.27 The White House, under
pressure to avoid the debt ceiling, went ahead with the second guarantee. One government
official later boasted that “the double federal guarantee should produce a virtually riskless
security with broad market acceptability.”28 Eventually investors became comfortable enough
with MBS that they no longer required such strong support. Still, these guarantees played a
crucial role in normalizing MBS and establishing the market in the first place.
Whereas Ginnie Mae would retain essential government functions, the rest of the old
Fannie Mae was to be privatized. The spin-off planning committee believed that Fannie would
need to be highly leveraged to be successful. They proposed to congress that Fannie Mae should
have no debt to equity ratio; if that met resistance, they suggested a ratio of 25 to 1. Even at the
dawn of the securitization market MBS promoted a high degree of leverage.

26

National Archives, RG51: Office of Management and Budget, Entry 37 Records of the Office of Budget Review, Budget
Methods Branch, 1952-1969, File” Participation Certificates – 1966. Feb 15, 1966. Minutes of the Advisory Committee on
Financial Assets.
27

Maisel Papers, May 11, 1967. Minutes of the Housing Credit Committee Meeting; National Archives, RG51: Office of
Management and Budget, Entry 37 Records of the Office of Budget Review, Budget Methods Branch, 1952-1969, File:
Participation Certificates – 1966. Feb 15, 1966. Minutes of the Advisory Committee on Financial Assets.
28

LBJ Archives, White House Central Files, Finance Files.

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There were differences between the PCs and the early MBS. Notably, the MBS were
designed to be more of a true sale of assets. To that end, investors received a pro rata share of the
pool and funds passed directly from the pool into the hands of investors. Yet the credit risks
associated with its new mortgage-bonds would continue to be largely absorbed by the
government. A Ginnie Mae guarantee and a $2.25 billion line of credit at Fannie Mae (and later
at Freddie Mac29 ) meant that the Treasury was on the hook if there was a credit problem with
these pools. But because the companies issuing the bonds were now fully private and the sales
were structured differently, these debt instruments would not be considered government
liabilities under the guidelines laid out by the PCBC.
Debates about the status of Fannie Mae and the proper accounting for those bonds did not
end with the spin-off of Fannie Mae. The Nixon administration would later assert in the Wall
Street Journal that Fannie Mae was effectively a shadow government agency, privatized only by
Johnson to hide the size of the Vietnam War budget. 30 In 1971 the Federal Reserve suggested
that the government reclassify GNMA securities in order to include them on the budgetary outlay
totals; this was thought to pave the way towards putting all of the government’s insured and
guaranteed securities on the books, including the FHA and VA loans, to the amount of $25 billion
annually (in comparison, the MBS at this time would add only $2 billion annually to the budget).
The Treasury, OMB, and HUD strenuously objected: “We are absolutely unconvinced by this
classification and appalled by the consequences.”31 The key point here is not that these MBS
29

In 1970 Freddie Mac was created in the same model as Fannie Mae. It was created under the FHLBB, in part because Savings
and Loans preferred to work through the FHLBB than with Fannie, which had traditionally been aligned with the Mutual Banks
and other investors that purchased FHA and VA insured loans. It was actually Freddie that took the lead in the issuance of MBS
throughout the 1970s, while Fannie largely stuck to portfolio lending until the 1980s.
30

LBJ Archives. Gaither Files.

31

National Archives RG51, E202, Housing CVA: HUD 1971-1972 G.(2) GNMA Mortgage Backed Securities. August 4th, 1971
letter from James Hill.

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necessarily belonged on the budget. Rather, the important thing to note is that the U.S.
government was working in a hybrid area that could have reasonably been classified in different
ways. Government officials, perhaps not unsurprisingly, seem to have picked the classification
that served their interests. In doing so, they created a multipurpose financial tool that would have
wide applicability once all the kinks were worked out.

Conclusion

President Johnson publicly proclaimed that the Housing and Development Act of 1968
was a way to bring private funds into a struggling market. But he glossed over important details
about why the government was so eager to access capital markets. This omission mattered. It
allowed Johnson to imply that the government was transforming housing finance mainly because
it supported private enterprise and homebuilding. It is true that the administration wanted to
support housing and private markets, but it is also true that the administration was driven by an
urgent need to get public funds out of the housing market. Facing a fiscal crisis caused by the
Vietnam War and the Great Society programs, Johnson first tried to solve his budgetary problems
by using a weaker version of privatization, one that used debt instruments to tap private funds
and remove the impact of Fannie Mae on the budget, but that kept control of housing finance
squarely in government hands. It was only when this effort failed that Johnson spun-off Fannie
Mae and laid the foundation for the American MBS market. Even then, the government
continued to absorb mortgage risks in less direct ways but significant ways.
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The basic form of the MBS was in place when the first one was issued in 1970. A group
of assets would be combined into a pool and investors purchased the right to revenues accruing
from the pool. The pool benefited from some kind of credit protection, a provision that reassured
investors that they could still get paid even if assets in the pool defaulted or lost their value.
Since all of this was done through a group of assets held in a Special Investment Vehicle that was
thought to contain any risks, neither the buyer nor seller had to hold reserves equivalent to the
amount required if they directly owned those collateralizing assets.
In the late 1960s and throughout the 1970s the government and a select group of
investors worked hard to convince the business world at large that it was a good idea to invest in
these new securities and, through them, in the housing market, using government supports to
advance the market. Many of the biggest developments in securitization throughout the 1970s
and 1980s – experiments with over-collateralization, insurance contracts, credit-default swaps,
and, most importantly, tranching – were intended to create risk management tools robust enough
to take the place of the Ginnie Mae guarantee. 32 In the middle of the 1980s, when all of this was
in place, a truly private market started to take off.
Many developments beyond the rise of securitization helped cause the credit and housing
bubbles that led to an economic crisis. In the 1970s and 1980s a series of deregulations stripped
away important government controls in housing and financial markets. Low interest rates
encouraged investors from around the world to pour money into American markets and
especially into American housing finance. Credit agencies that were supposed to police credit
markets were swayed by conflicts of interests and failed to adequately evaluate MBS risks. In

32

Entrepreneurs also worked to changed tax laws, better managing prepayment risks, and educating investors.

Shreds and Patches | 28

this environment, securitization served as a powerful accelerant. I suspect that by the close of the
1990s the same things that made the MBS such an efficient solution for Johnson – a capacity to
parse risk and ownership, the ability to move unwanted assets off a balance sheet, a level of
obscurity that rendered these deals unintelligible to the lay person, and, most of all, a structure
that justified a more risky, highly leveraged balance sheet – all served to fuel the subprime
market and credit bubble.
Attending to the place of credit lending and budget politics in these events matters
because it has implications for how we think about the ultimate misuse of MBS. When the U.S.
government turned to credit lending to help promote its markets, it had ramifications far beyond
the immediate development of housing or agriculture or small businesses. The government’s
credit programs helped change the techniques and concepts used across credit markets. They also
reshaped the boundaries of the federal budget and pioneered the use of MBS, one of the most
important financial technologies of our time. It is true that MBS were designed to manage risks
and encourage lending. It is also true that they were designed to remove assets from balance
sheets and increase leverage. So if we find today that MBS have made it difficult to measure
what risks companies hold, or that they have encouraged companies to assume a higher ratio of
obligations to equity, we would do well to remember that, to some extent, this is exactly what
MBS were designed to do. As we collectively look back to make sense of the current economic
meltdown, we should keep in mind that if the balance sheets of today’s banks are things of shreds
and patches, it is in part because they followed the lead of the federal budget.

Shreds and Patches | 29

Shreds and Patches | 30

Bibliography
Black, Deborah G., Kenneth D. Garbade, and William L. Silber. 1981. "The Impact of the
GNMA Pass-Through Program on FHA Mortgage Costs." The Journal of Finance
36:457-469.
Block, Fred. 2008. "Swimming Against the Current: The Rise of a Hidden Developmental State
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Bruce G. Carruthers, Arthur Stinchcombe. 1999. "The Social Structure of Liquidity: Flexibility,
Markets and States. ." Theory and Society. 28:353-382.
Budget, United States. Office of Management and. 1965. "Special Analyses, Budget of the
United States Government." edited by E. O. o. t. President. Washington, D.C.: U.S. GPO.
Carter, Susan B., Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch,
Gavin Wright, and Kenneth A. Snowden. 2006. Historical Statistics of the United States
Millennial Edition Online. New York: Cambridge University Press.
Concepts, President's Commission on Budget. 1967. Report of the President's Commission on
Budget Concepts. Washington, D.C.: U.S. G.P.O.
Congressional Budget Office, U. S. (1978). Loan Guarantees: Current Concerns and Alternatives for
Control: A Compilation of Staff Working Papers. C. B. Office. Washington: xv, 58 p.

Fish, Gertrude Sipperly. 1979. The Story of Housing. New York: Macmillan.
Green, Richard K. and Susan M. Wachter. 2005. "The American Mortgage in Historical and
International Context " The Journal of Economic Perspectives 19:93-114.
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House, U.S. 1964. A Study of Federal Credit Programs, Edited by C. o. B. a. C. Subcommittee
on Domestic Finance, House of Representatives, 88th Congress, 2d session. Washington: U.S.
GPO.
House, U.S. Congress. 1966. "Sale of Participations in Government Agency Loan Pools." edited
by t. C. Committee on Banking and Currency, second session. Washington: U.S.
Government Printing Office.
Jessen, Richard. 1964. "Housing Bill, Signed by President, Lifts Aid to Persons, Cities, Firms:
Johnson Calls $1.5 Billion Act Milestone Though It Lacks Some Sections He Sought." in
Wall Street Journal.
Krippner, Greta R. 2001. "The Elusive Market: Embeddedness and the Paradigm of Economic
Sociology." Theory and Society 30:775-810.
Moss, David A. 2002. When all else fails : government as the ultimate risk manager. Cambridge,
Mass.: Harvard University Press.
Novak, William J. 1996. The people's welfare : law and regulation in nineteenth-century
America. Chapel Hill, [N.C.] ; London: University of North Carolina Press.
Quigley, John M. 2006. "Federal Credit and Insurance Programs: Housing." Federal Reserve
Bank of St. Louis Review 88:281-309.

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Ranieri, Lewis S. 1996. "The Origins of Securitization, Sources of its Growth, and its Future
Potential." Pp. 31-44 in A Primer on Securitization edited by L. T. Kendall and M. J.
Fishman. Cambridge, Mass.: MIT Press.
Sellon, Gordon H. Jr. and Deana VanNahmen. 1988. "The Securitization Of Housing Finance."
Economic Review - Federal Reserve Bank of Kansas City 73:3-20.
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Congress. Washington, D.C.: U.S. Government Printing Office.
Stark, John. 1964. "A Study of Federal Credit Programs." edited by U. S. House. Washington:
U.S. GPO.
Tickton, Sidney G. 1955. The Budget in Transition: a staff study prepared for the NPA Business
Committee. Washington: National Planning Associaion.
United States. Congress. House. Committee on Banking and Currency. 1964. A study of Federal
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Print. Off.
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Weber, Max, Hans Heinrich Gerth, and C. Wright Mills. 1946. From Max Weber: Essays in
sociology. New York,: Oxford University Press.

Shreds and Patches | 32

Table 1: Federal Credit Aid, 1932-1950 (in billions of dollars)
Sector

Program Type 1932-36
1937-41
1942-46
1947-50
Finance
Direct loans
3.681
0.256
0.055
0.008
Business
Direct loans
0.959
0.673
2.999
2.475
Business
Insured
0.074
0.086
1.878
0.452
Agriculture (real estate) Direct loans
2.165
0.604
0.74
0.881
Agriculture (other)
Direct loans
2.935
3.947
6.273
8.703
Private housing
Direct loans
3.435
1.646
1.505
3.803
Private housing
Insured
0.908
4.356
5.614
18.509
Local government
Direct loans
1.062
1.719
0.467
0.262
Local government
Insured
0
0.057
0.677
0.549
Misc
Direct loans
0.144
0.158
0.073
0.115
Total
15.363
13.502
20.281
35.757
Note: “Insured” includes federal guarantee programs.
Source: R. J. Salunier, H. O. Halcrow, and N. H. Jacoby, "Federal Lending and Loan
Insurance" (Princeton: Princeton University Press, 1958); Appendix A; "Final Report on the
Reconstruction Finance Corporation" (Washington: Government Printing Office, 1969), tables in
appendix; and data presented in tables A-2, A-3, sod A-4.; as cited in Federal Credit Programs
(United States. Congress. House. Committee on Banking and Currency. 1964)

Table 2: Terms on Mortgages for Existing Homes, Selected Years

Year
1950
1952
1954
1958
1960
1962
1964
1966

FHA
(Average)
20.2
19.7
20.1
24.2
25.8
27.4
28.4
28.4

Maturity
VA
(Average)
19.7
18.7
21.4
22.3
23.6
26.6
27.7
27.8

Conventional
(Median)
12.3
13.9
14.6
15.5
16.5
18.8
20.9
22.2

Loan-to-Value Ratio
FHA
VA
Conventional
(Average) (Average)
(Median)
76.4
86.4
64.6
76.1
80.3
64.1
77.8
86.8
65.2
88.1
87.4
68.9
90.5
90.7
72
92.1
94.9
75.1
92.8
96.2
76.1
93
96.8
74.5

Source: Snowden, Kenneth A., “Terms on nonfarm home mortgages, by type of mortgage and
holder: 1920–1967.” Table Dc1192-1209 in Carter et al. 2006.

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Figure 1: Direct vs. Insured Loans as a Portion of Federal Credit Aid, 1932-1950

Source: R. J. Salunier, H. O. Halcrow, and N. H. Jacoby, "Federal Lending and
Loan Insurance" (Princeton: Princeton University Press, 1958); Appendix A;
"Final Report on the Reconstruction Finance Corporation" (Washington:
Government Printing Office, 1969), tables in appendix; and data presented in
tables A-2, A-3, sod A-4, as cited in Federal Credit Programs (House 1964).

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Figure 2: Federal Credit Aid, 1932-1950: Direct and Insured Debt by Sector
(in billions)

Source: R. J. Salunier, H. O. Halcrow, and N. H. Jacoby, "Federal Lending and Loan Insurance" (Princeton:
Princeton University Press, 1958); Appendix A; "Final Report on the Reconstruction Finance
Corporation" (Washington: Government Printing Office, 1969), tables in appendix; and data presented in tables A-2,
A-3, sod A-4; as cited in Federal Credit Programs (House 1964).

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Figure 3: U.S. Mortgage Debt, 1939-1970 (in billions)

Note: The numbers for federally held debt represents farm and nonfarm debt; the federally underwritten portion is
calculated based on nonfarm debt only. For federally underwritten debt from 1939-1944, values represent only
FHA and VA loans on 1-4 family homes and so are likely a small underestimation. For 1944 onwards, this is total
federally underwritten nonfarm debt.
Source: Snowden, Kenneth A. “Mortgage debt, by type of property, holder, and financing: 1939–1999.” Table
Dc929-949 in Carter et al 2006. Online: http://dx.doi.org/10.1017/ISBN-9780511132971.Dc903-1288

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Figure 4: Federal Mortgage Credit as a Portion of U.S. Mortgage Debt, 1939-1970

Note: The numbers for federally held debt represents farm and nonfarm debt; the federally underwritten portion is
calculated based on nonfarm debt only. For federally underwritten debt from 1939-1944, values represent only
FHA and VA loans on 1-4 family homes and so are likely a small underestimation. For 1944 onwards, this is total
federally underwritten nonfarm debt.
Source: Snowden, Kenneth A. “Mortgage debt, by type of property, holder, and financing: 1939–1999.” Table
Dc929-949 in Carter et al 2006. Available online: http://dx.doi.org/10.1017/ISBN-9780511132971.Dc903-1288

Shreds and Patches | 37

Figure 5: Financing of Federal Credit Programs in 1964

Source: Federal Credit Programs (United States. Congress. House. Committee on Banking and
Currency. 1964)

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Figure 6: Actual Disbursements vs. Reported Expenditures for Federal Credit Programs,
1961 to 1966

Note: Amounts for 1965 and 1966 are estimates. Actual amounts are provided from 1961-1964.
Source: Special Analyses: Budget of the United States Government, Washington, D.C.: Executive Office of the
President. 1963, 1964, 1965, 1966

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