Fannie Freddie Freak Out: Part One

Like kooky old relatives who you sort of know but don’t really encounter until that fateful family event where they create a scene, the solvency of Fannie Mae and Freddie Mac have taken center stage as the most important financial issue right now. In fact, it may be the only story that can displace the Jolie/Pitt twins. Today and tomorrow I am going to explain why this story is so important and how it could affect you.

Let’s start with a little history lesson. Congress created Fannie Mae in 1938 as part of FDR’s New Deal to ensure money for home mortgages would be reliably available, while Freddie Mac was created by Congress in 1970 with a mission to provide liquidity, stability and affordability to the nation's mortgage markets. This was all done to help accomplish the national quest of home ownership for all (for more on my opinion on that topic, see my article from July 2, “Home Ownership Myths”).

Fannie and Freddie don't make home loans, but they provide stability and liquidity to the mortgage market by guaranteeing that investors who buy mortgage securities will receive timely payments of principal and interest. In practice, both companies buy mortgages, package them into securities and sell them to investors and also hold mortgages in their own portfolios. Combined, Fannie and Freddie own or guarantee about $5.2 trillion of the $12 trillion U.S. home-mortgage debt outstanding. The vast majority of the mortgages they back are fixed-rate, prime loans that went to borrowers with good credit, not the scary sub-prime stuff that has brought down other institutions.

Because Congress was involved with their formation, both entities are considered, “government-sponsored enterprises,” or GSEs, but they are both privately owned by shareholders. Despite being private, Fannie and Freddie receive special privileges, the most important of which is the widespread belief that if either fell on hard times, the government would be there for them. The government has consistently emphasized that it does not guarantee either Fannie or Freddie’s debts, but it is common wisdom that Uncle Sam would provide a safety net, which has allowed both to borrow money at lower interest rates, enabling them to make loans more cheaply. The other privilege that the companies enjoy is more lenient capital requirements, because regulators and Congress believed that there wasn't much risk of wide-spread defaults on home mortgages---a concept that sounds quaint at best, in light of the current housing mess.

The Fannie and Freddie advantage amounts to a strange situation where profits have been privatized but losses are socialized. In other words, if the companies do well, the shareholders make money. But, if the bets go sour, the government (meaning you and me, of course) eats the losses. If this isn’t the definition of moral hazard, what is? If you know that you get to keep the marbles when you bet big, but Uncle Sam carries you on his back if you blow it, wouldn’t you assume a lot of risk?

This is a system that encouraged lots of leverage, which means that any change in the underlying value of the assets can wreak havoc on the companies. Looking at Fannie and Freddie’s balance sheets at the end of last quarter, you see that there is a face value of $1.7 trillion in mortgages, supported by assets of $70 million in core capital. Combined, that equates to leverage of 24 to 1, but when you add in their off-balance sheet guarantees, the figure rises to almost 70 to 1! You don’t need to be an economist or an accountant to know that with home prices plummeting, this bet went sour fast and furiously. Tomorrow, I will review how Fannie and Freddie’s problems could affect you.