Liability of Fannie and Freddie

In a controversial move during the Financial Crisis, the United States treasury effectively took over home-mortgage companies Fannie Mae and Freddie Mac by placing them into conservatorships. The federal government took conclusive steps to do what it had implicitly done for years: use the US credit to stand behind the debts of these Government-Sponsored Entities. While many have viewed this act as overreaching on the part of the government, under the laws of agency, the government would have been liable for their losses anyway.

The history of Fannie and Freddie can help explain how the laws of agency can apply to these Government-Sponsored Entities. While technically not under the direct control of the government, the two corporations were originally founded by President Roosevelt and Congress to purchase mortgages from cash poor banks. As response to the Vietnam war, the two entities were spun off of the government's balance sheet and made publicly traded corporations. But, as David Wessel describes in his book In Fed We Trust, both Fannie and Freddie maintained implicit backings from the government:

Since 1972, they had been owned by shareholders and run for profit, but they borrowed all over the world at low interest rates because investors, including the Chinese government, assumed—correctly—that the U.S. government stood behind their debt, even though it didn't have any legal obligation to do so.

Wessel's conclusions about legal obligations notwithstanding, the point that he makes about the government standing behind Fannie and Freddie's debt is important in terms of agency law. Investors from around the world noted that these GSEs were closely liked to the government's pocketbook and made their investment decisions based on the implication of this implicit government sponsorship. From the standpoint of United States Agency law, this is an important characteristic of these entities acting as agents of the US government.

Under the structure set up by the US Government, the definition of Agency by Estoppel. Essentially, estoppel agency comes down to three criteria that can establish liability of principles by agents, all of which were met by Fannie and Freddie as agents of the US Government. The first is that the principle causes a third party to believe that an agent has an authority to act on the principle's behalf. In the case of Fannie and Freddie, the government originally set up the entities and they remained GSEs. The second criterion is that the principle has notice of the third party's incorrect belief but takes no steps to rectify the incorrect belief; this point is more contentious, but it seems reasonable that the government would have noticed the cheaply sourced international funding that the companies were receiving, and clearly they did not do say anything to deny their involvement with Fannie and Freddie (implicit or otherwise). Finally, the third party would justifiably change their position with the correct knowledge of the agent's lack of authority. This seems to be pretty clear with the corporations as lenders would have demanded a higher risk premium inline with corporate bonds as opposed to premiums more inline with government credit. Since both Fannie and Freddie meet the requirements of Agency by Estoppel, this would cause the government to be liable for their debts, regardless if they had been taken over or not.