The aggressive and dramatic government intervention of the nation’s two largest mortgage finance companies brings with it a foregone conclusion to the 2008 game of Bailout Bingo. The music did not stop due to any specific event, rather Treasury Secretary Henry Paulson was forced to acknowledge that without government help, credit and equity markets would be left twisting in the wind, or worse. So now that the bailout of Fannie Mae and Freddie Mac is official, it’s time to break down the plan and identify the winners and losers.
By placing the GSEs into “conservatorship,” the government is basically allowing them to complete a much-needed reorganization where they will be recapitalized. While the initial commitment by the Treasury is $1 billion, Paulson has committed as much as $100 billion to each company to provide a backstop in capital shortfalls. Under the terms of the plan, the government will be able to buy the companies outright at a small cost. The structure that will enable that process includes:
· The plan does not eliminate the common and preferred shares of either institution, but the companies will stop paying dividends on existing common and preferred shares. In essence, common stockholders will likely be wiped out eventually and preferred stockholders will take a massive haircut on the value of their shares.
· Senior Preferred Stock will be issued to the government, which will take precedence over all other types of equity.
· The Treasury will purchase $1 billion of preferred stock from each GSE. The stock will pay a dividend to the government of 10%, which can rise to 12% if either company misses its dividend payments.
· The Treasury will receive warrants that will entitle it to ultimately own 79.9% of each company.
· The government plans to buy significant amounts of mortgage-backed securities on the open market, beginning with the purchase of $5 billion worth this month.
· Beginning on March 31, 2010, the GSEs will pay what is essentially a management fee to the Treasury for all of its past efforts. The fee may be paid in cash or in additional issues of preferred stock.
Beyond the capital restructuring, the top brass at each company is OUT, replaced by the Federal Housing Finance Agency (FHFA). Two veterans of the industry will be brought in to run the companies during the reorganization. The new CEO of Fannie will be Herbert Allison, Jr., the former chairman of TIAA-CREF, succeeding Daniel Mudd and David Moffett, the recently-retired CFO of U.S. Bancorp, will replace Richard Styron of Freddie. Suffice to say that losing their jobs is not close to what should happen to these two, whose “stewardship” has been laughable. If they are able to collect their severance, retirement benefits or deferred compensation, it would be a travesty. Mudd has already taken home $12.4 million in cash since taking over Fannie in 2004 and Styron has pocketed $17.1 million in pay and stock options since 2003. That seems to be plenty, thank you very much!
Winners and Losers:
So who wins and losses under this vast plan? Let’s start with the Biggest Losers—US! Yes, the good ol’ American taxpayer is going to be on the hook for all of this debt, most of which was not our doing. It is unclear how much this clean up will cost—early estimates put the number at $200 billion, but until the housing market finds a bottom, we will not know the real damage. Until then, sit tight and try to imagine how the next administration is NOT going to raise taxes.
The common and preferred stock holders are going to lose—big time. Of course, this point seems silly now—common shareholders have already lost approximately 90% over the past year. This group includes some storied value mutual fund managers, like Bill Miller of Legg Mason, David Dreman and Martin Whitman, all of whom held and in some cases, increased, their holdings in both Fannie and Freddie. Among the preferred shareholders are some fairly large regional banks, like Sovereign Bancorp, which holds approximately 13% of its tangible capital in GSE preferred stock, and Midwest Banc Holdings of Illinois and Gateway Financial Holdings of Virginia and North Carolina.
The next loser is the free market. I don’t want to get all crazy on this one, because once the system went so completely awry, there were not a lot of good choices. Again, let’s not kid ourselves: the owners of Fannie and Freddie made a ton of money on the way up and now the government is socializing their losses. Of course, Wall Street, the bastion of “heads we win and tails you lose”, is happy with the deal, because it allows the institutions to continue operating. By keeping Fannie and Freddie afloat, the government will likely restore over a billion dollars worth of fees to the Street, which should help the big firms claw their way back into the black.
Other winners include those who are shopping for a mortgage (it is estimated that the plan will allow mortgage rates to decline by .25% or so); Bill Gross, the CIO of PIMCO, which owns $500 billion worth of mortgage-backed securities (wasn’t that Bill who last week squawked that the US had to bail out Fannie or Freddie or risk a financial system melt-down?). Yesterday, US equity owners were winners, although the reaction could be a one-day wonder, but heck, in this environment, we’ll take it! Finally, the former Fannie and Freddie CEOs, as noted above, have reaped the most amazing benefits, even as the music stopped in our game of Bailout Bingo.
Showing posts with label Fannie Mae and Freddy Mac. Show all posts
Showing posts with label Fannie Mae and Freddy Mac. Show all posts
Monday, September 8, 2008
Fan/Fred I Are Dead: Long Live Fan/Fred II!
Why is it that they always drop the bomb after the close on a Friday? That’s what the panel of Fox Business’ “Bulls and Bears” noted during a commercial Friday at about 4:15 pm, after Wall Street Journal writer Deborah Solomon joined us after breaking the story of the government bail-out of Fannie Mae and Freddie Mac.
I opined that the “on-the-record” rationale was that the parties involved needed a weekend to iron out the details (as if they have not been working on this massive endeavor for months!), while the not-so-subtle benefit was that the news would make the hedge funds crazy and potentially cost them some money. Regardless of the timing, the group agreed that action was necessary, if not wholly desired on an intellectual level.
At the time of this writing (Saturday afternoon), the details of the plan were not fully known, but it is believed that the US government is about to make its backing of mortgage giants Fannie Mae and Freddie Mac from implicit to explicit. According to people briefed on the secret discussions, the companies are likely to be into government conservatorship of their regulator, the Federal Housing Finance Agency; the current executives and boards of the two companies will be replaced; common stockholders (and potentially preferred shareholders) would be virtually wiped out; and the companies will continue to function because the government will now be standing behind the debt on their balance sheets. In essence, the government will temporarily run the companies, probably by injecting capital on a quarter-by-quarter basis.
For those who thought the government’s role in Bear Sterns was a big deal, fasten your seatbelts—according to Solomon, this “would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago.” This makes everyone seethe, including me. But once the barn door was open on the situation, I am not sure what the alternative could have been. After all, Fannie and Freddie own or guarantee more than $5 trillion of mortgages and given the state of the already depleted housing market (Fan/Fred are now responsible for nearly 70% of new loans), it was simply untenable to allow them to fail and for the mortgage market to completely seize up.
Treasury Secretary Paulson knew as much, which is why he sought and eventually gained the authority to intervene in the two companies at the height of fear in July. Since then, federal officials have been working with bankers at Morgan Stanley (they are only charging Uncle Sam for overhead, not their customary consulting fees) to figure out how to untangle the mess. The answer is now becoming clearer— Fan/Fred will continue to operate as the government cleans up and restores their balance sheets. How do we all participate in this fiasco? Well, US taxpayers will be on the hook for the huge potential liabilities of the companies, which some estimate to be somewhere in the $40-$50 billion range. This is why we should invoke the old English mantra: Fan/Fred I Are Dead: Long Live Fan/Fred II!
I opined that the “on-the-record” rationale was that the parties involved needed a weekend to iron out the details (as if they have not been working on this massive endeavor for months!), while the not-so-subtle benefit was that the news would make the hedge funds crazy and potentially cost them some money. Regardless of the timing, the group agreed that action was necessary, if not wholly desired on an intellectual level.
At the time of this writing (Saturday afternoon), the details of the plan were not fully known, but it is believed that the US government is about to make its backing of mortgage giants Fannie Mae and Freddie Mac from implicit to explicit. According to people briefed on the secret discussions, the companies are likely to be into government conservatorship of their regulator, the Federal Housing Finance Agency; the current executives and boards of the two companies will be replaced; common stockholders (and potentially preferred shareholders) would be virtually wiped out; and the companies will continue to function because the government will now be standing behind the debt on their balance sheets. In essence, the government will temporarily run the companies, probably by injecting capital on a quarter-by-quarter basis.
For those who thought the government’s role in Bear Sterns was a big deal, fasten your seatbelts—according to Solomon, this “would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago.” This makes everyone seethe, including me. But once the barn door was open on the situation, I am not sure what the alternative could have been. After all, Fannie and Freddie own or guarantee more than $5 trillion of mortgages and given the state of the already depleted housing market (Fan/Fred are now responsible for nearly 70% of new loans), it was simply untenable to allow them to fail and for the mortgage market to completely seize up.
Treasury Secretary Paulson knew as much, which is why he sought and eventually gained the authority to intervene in the two companies at the height of fear in July. Since then, federal officials have been working with bankers at Morgan Stanley (they are only charging Uncle Sam for overhead, not their customary consulting fees) to figure out how to untangle the mess. The answer is now becoming clearer— Fan/Fred will continue to operate as the government cleans up and restores their balance sheets. How do we all participate in this fiasco? Well, US taxpayers will be on the hook for the huge potential liabilities of the companies, which some estimate to be somewhere in the $40-$50 billion range. This is why we should invoke the old English mantra: Fan/Fred I Are Dead: Long Live Fan/Fred II!
Friday, August 29, 2008
Not Enough of a Shake up
“Fannie Mae shook up its senior management in a move it said was designed to ‘drive’ the mortgage company’s efforts to conserve capital and contain a surge in costs stemming from defaults by homeowners.” (WSJ “Fannie Names New Officers in Shake-Up” August 28). Given that Fannie’s stock is down 90% from a year ago, this move is akin to the Captain of the Titanic naming a new First Mate two hours after hitting the iceberg.
CEO Daniel Mudd, who has presided over Fannie Mae since the embarrassing accounting scandal that ended Franklin Raines’ tenure in 2004, said that the move to replace CFO Stephen Swad and Chief Business Officer Robert Levin was intended to restore investor confidence in the mortgage giant, as if a shuffle would do that! After logging billions of dollars of losses ($9.4B, to be exact) over the past four quarters, isn’t it interesting that the guy who was in CHARGE still has a job? It makes me hearken back to Merrill Lynch’s Stan O’Neal, who after presiding over Merrill’s decline, at least had the decency to step down.
Shady dealings at the top of Fannie must be a job requirement. When fudging the numbers doesn’t work, just put the political pressure on to ensure that the regulatory environment is lax. (With enough money, your new BFF Barney Frank’s got your back!) With the Feds lying low, you then assume boatloads of risk and if the bet goes bad, “shake up” your staff, but preserve your own precious job.
As Fox Business News’ Elizabeth MacDonald recently put it (check out her excellent blog at http://emac.blogs.foxbusiness.com/):
“The way these two companies [Fannie Mae and Freddie Mac] recklessly built and operated their Ponzi-type business model boggles the mind. Teetering atop their combined $54 billion net worth is a breathtaking pyramid of debt and assets, $5 trillion. That capital amounts to less than 1% of the mortgages they either own or back…Instead of shutting the spigot off, the two bought subprime and Alt-A securitizations through 2007 when the housing bubble burst, picking up the slack for banks when Wall Street shut down its printing press factory cranking out a drunken daisy chain of asset-backed paper. This is beyond impenetrably stupid. It’s obscene.”
And what may be most obscene is that CEO Daniel Mudd still has a job. If or when the government intervenes to bail out Fannie Mae and Freddie Mac, which looks more and more likely with each day, the first order of business should be to remove the CEO’s who knew exactly what was going on and allowed the mess to go on well beyond any reasonable time horizon. If Mr. Mudd truly believes his own words, “As we move through the bottom of this cycle, maintaining capital, managing credit and driving revenues are priorities and we have to organize the staff accordingly,” then he would do more than replace his convenient scapegoats: he would be a man, take responsibility for his actions and step down. At this point, these actions are just not enough of a shake up.
CEO Daniel Mudd, who has presided over Fannie Mae since the embarrassing accounting scandal that ended Franklin Raines’ tenure in 2004, said that the move to replace CFO Stephen Swad and Chief Business Officer Robert Levin was intended to restore investor confidence in the mortgage giant, as if a shuffle would do that! After logging billions of dollars of losses ($9.4B, to be exact) over the past four quarters, isn’t it interesting that the guy who was in CHARGE still has a job? It makes me hearken back to Merrill Lynch’s Stan O’Neal, who after presiding over Merrill’s decline, at least had the decency to step down.
Shady dealings at the top of Fannie must be a job requirement. When fudging the numbers doesn’t work, just put the political pressure on to ensure that the regulatory environment is lax. (With enough money, your new BFF Barney Frank’s got your back!) With the Feds lying low, you then assume boatloads of risk and if the bet goes bad, “shake up” your staff, but preserve your own precious job.
As Fox Business News’ Elizabeth MacDonald recently put it (check out her excellent blog at http://emac.blogs.foxbusiness.com/):
“The way these two companies [Fannie Mae and Freddie Mac] recklessly built and operated their Ponzi-type business model boggles the mind. Teetering atop their combined $54 billion net worth is a breathtaking pyramid of debt and assets, $5 trillion. That capital amounts to less than 1% of the mortgages they either own or back…Instead of shutting the spigot off, the two bought subprime and Alt-A securitizations through 2007 when the housing bubble burst, picking up the slack for banks when Wall Street shut down its printing press factory cranking out a drunken daisy chain of asset-backed paper. This is beyond impenetrably stupid. It’s obscene.”
And what may be most obscene is that CEO Daniel Mudd still has a job. If or when the government intervenes to bail out Fannie Mae and Freddie Mac, which looks more and more likely with each day, the first order of business should be to remove the CEO’s who knew exactly what was going on and allowed the mess to go on well beyond any reasonable time horizon. If Mr. Mudd truly believes his own words, “As we move through the bottom of this cycle, maintaining capital, managing credit and driving revenues are priorities and we have to organize the staff accordingly,” then he would do more than replace his convenient scapegoats: he would be a man, take responsibility for his actions and step down. At this point, these actions are just not enough of a shake up.
Friday, August 22, 2008
Cover Your Fannie...and Freddie too
“IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac. It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses.”- Jonathan Lang in Barron’s August 18, 2008
And so began phase two of the Fannie and Freddie “deathwatch” on Wall Street. Perhaps you thought that the crisis over the two government-sponsored enterprises (GSEs) had passed in July when the Treasury Department stepped in and quelled frayed nerves. The Barron’s article highlighted the fact that the continuing decline in real estate values has led to a spike in mortgage delinquencies and foreclosures, which in turn have severely damaged the balance sheets of both Fannie and Freddie.
While the two companies may be adequately capitalized according to their regulator’s current definition, according to Barron’s, “On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.”
While both companies maintain that they have enough money to weather this storm (remember when Bear Sterns said the same thing a week before it practically filed for bankruptcy?), it has become clear that the GSEs need to raise cash and fast. But who in his right mind would take the plunge right now? Two weeks ago, the companies added another $3.1 billion in losses to the $11 billion they had already reported in recent quarters. Talk about throwing good money after bad!
When in doubt, you can count on good ol’ Uncle Sam to provide the big-time safety net. Last month, Congress gave the Treasury Department the authority to lend money to the firms or take an equity stake in them. It is estimated that the federal government would have to pump approximately $20 billion into each company, possibly through a guarantee rather than through a direct injection of capital. Legislation passed last month allows the government to do so to stabilize financial markets and to prevent disruption in the mortgage industry. Barron’s noted that a government bail-out might “take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends.”
Time is ticking for Fannie and Freddie but one thing is for sure: investors are convinced that the government will take steps to end the patient’s suffering. We can only hope that the end is swift and as painless as possible.
And so began phase two of the Fannie and Freddie “deathwatch” on Wall Street. Perhaps you thought that the crisis over the two government-sponsored enterprises (GSEs) had passed in July when the Treasury Department stepped in and quelled frayed nerves. The Barron’s article highlighted the fact that the continuing decline in real estate values has led to a spike in mortgage delinquencies and foreclosures, which in turn have severely damaged the balance sheets of both Fannie and Freddie.
While the two companies may be adequately capitalized according to their regulator’s current definition, according to Barron’s, “On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.”
While both companies maintain that they have enough money to weather this storm (remember when Bear Sterns said the same thing a week before it practically filed for bankruptcy?), it has become clear that the GSEs need to raise cash and fast. But who in his right mind would take the plunge right now? Two weeks ago, the companies added another $3.1 billion in losses to the $11 billion they had already reported in recent quarters. Talk about throwing good money after bad!
When in doubt, you can count on good ol’ Uncle Sam to provide the big-time safety net. Last month, Congress gave the Treasury Department the authority to lend money to the firms or take an equity stake in them. It is estimated that the federal government would have to pump approximately $20 billion into each company, possibly through a guarantee rather than through a direct injection of capital. Legislation passed last month allows the government to do so to stabilize financial markets and to prevent disruption in the mortgage industry. Barron’s noted that a government bail-out might “take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends.”
Time is ticking for Fannie and Freddie but one thing is for sure: investors are convinced that the government will take steps to end the patient’s suffering. We can only hope that the end is swift and as painless as possible.
Wednesday, July 16, 2008
Fannie Freddie Freak Out: Part Two
Yesterday I talked about some of the basic facts about the two Government Sponsored Enterprises, mega-mortgage facilitators Fannie Mae and Freddie Mac. Today let’s turn our attention to the implications of the story—how does the bad behavior of your kooky old relatives, Fannie and Freddie, affect you?
The first question that comes to mind is, “What happens if either Fannie or Freddie were involved with my mortgage?” The answer is easy: NOTHING. Even if the government literally took over the two companies, which has not yet occurred, keep paying your monthly mortgage! In fact, paying your mortgage on time should always be your number one financial priority.
The more interesting question is what might happen to the general mortgage market for those who are interested in re-financing or those seeking a brand new mortgage? Without Fannie and Freddie, the market for mortgages would be even tougher than it is now. Together Fannie and Freddie have bought 80% of new mortgages in the US this year from banks and mortgage lenders -- losing that demand would be deadly for the already-beleaguered housing market, which is why the government is doing everything in its power to ensure that the companies continue to function.
But the whole thing is circular: when there are too many homes for sale, prices plunge, lowering the value of the assets on Fannie and Freddie’s balance sheet. With less capital available, the two kooks reduce the amount of lending activity or are forced to raise the cost of a loan. Concurrently, when prices fall, it leads to more foreclosures, as homeowners find it nearly impossible to refinance their existing mortgages. This “negative feedback loop” can build on itself and become a self-fulfilling nightmare, which throws the economy and the financial markets into disarray. (Conversely, some have estimated that if Fannie and Freddie were in stronger financial shape, mortgage rates could be lower by as much as a quarter of a point, helping to heal the housing markets.) This is why the government had to announce a plan to stop the bleeding.
On Sunday, the Bush administration asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. In a separate announcement, the Fed said that it would make one of its short-term lending programs, the so-called “discount window”, available to Fannie Mae and Freddie Mac. If these actions do not do the job, Fannie and Freddie could fall under the control of their government regulator, which would then be responsible for the firm. That step -- known as placing it in a “conservatorship” would allow the mortgage company to continue operating, but how efficiently is unknown. Clearly, this would be a last resort for the government.
For those who want “someone to pay”, don’t worry: shareholders of the two companies have lost approximately 80% of the value of their investments this year alone. I don’t know about you, but that does not make me feel too good in this environment.
The first question that comes to mind is, “What happens if either Fannie or Freddie were involved with my mortgage?” The answer is easy: NOTHING. Even if the government literally took over the two companies, which has not yet occurred, keep paying your monthly mortgage! In fact, paying your mortgage on time should always be your number one financial priority.
The more interesting question is what might happen to the general mortgage market for those who are interested in re-financing or those seeking a brand new mortgage? Without Fannie and Freddie, the market for mortgages would be even tougher than it is now. Together Fannie and Freddie have bought 80% of new mortgages in the US this year from banks and mortgage lenders -- losing that demand would be deadly for the already-beleaguered housing market, which is why the government is doing everything in its power to ensure that the companies continue to function.
But the whole thing is circular: when there are too many homes for sale, prices plunge, lowering the value of the assets on Fannie and Freddie’s balance sheet. With less capital available, the two kooks reduce the amount of lending activity or are forced to raise the cost of a loan. Concurrently, when prices fall, it leads to more foreclosures, as homeowners find it nearly impossible to refinance their existing mortgages. This “negative feedback loop” can build on itself and become a self-fulfilling nightmare, which throws the economy and the financial markets into disarray. (Conversely, some have estimated that if Fannie and Freddie were in stronger financial shape, mortgage rates could be lower by as much as a quarter of a point, helping to heal the housing markets.) This is why the government had to announce a plan to stop the bleeding.
On Sunday, the Bush administration asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. In a separate announcement, the Fed said that it would make one of its short-term lending programs, the so-called “discount window”, available to Fannie Mae and Freddie Mac. If these actions do not do the job, Fannie and Freddie could fall under the control of their government regulator, which would then be responsible for the firm. That step -- known as placing it in a “conservatorship” would allow the mortgage company to continue operating, but how efficiently is unknown. Clearly, this would be a last resort for the government.
For those who want “someone to pay”, don’t worry: shareholders of the two companies have lost approximately 80% of the value of their investments this year alone. I don’t know about you, but that does not make me feel too good in this environment.
Tuesday, July 15, 2008
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.
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.
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