Fannie Mae and Freddie Mac: What Next?

In late 2007, shares of stock in Freddie Mae and Fannie Mac each traded above $60 per share. Shortly thereafter, the real estate bubble began to deflate, and share prices tumbled. For the next six months, investors assumed that the American mortgage behemoths were strong enough to weather the storm, and some degree of confidence was restored. In the summer of 2008, it was suddenly revealed that both institutions’ respective capital positions were significantly weaker than previously estimated, and their respective stock prices once again tumbled. In total, 90% of their shareholder value (a combined total of more than $50 Billion) has been wiped out.

Unfortunately, the structural weakening (to put it mildly) of Fannie Mae and Freddie Mac has happened so suddenly, and so violently, that there simply isn’t time to dwell on the past. "Despite repeated assurances from regulators…financial markets have concluded that by some measures they are deeply troubled. Freddie, for instance, is technically insolvent under fair value accounting rules, in which the company puts a market value on assets as if it had to sell them now."

The Bush Administration has already taken several measures to shore up both companies, culminating with an expensive bailout. Below, I will explore the forms this bailout could plausibly assume, several scenarios for the future of Fannie and Freddie, and the implications for homeowners and investors. First, however, some lingering questions regarding the seriousness of their condition need to be answered.

  1. How Bad is It?: In the last twelve months, Fannie and Freddie have reported a combined $14 Billion in losses. "Executives believe the housing market is only about halfway through its downward cycle…they expect the firm’s losses would increase through at least 2009, and that home prices would continue to decline by as much as an additional 9 percent." Unfortunately, a clear picture is difficult to obtain because the companies are subject to conflicting standards and can manipulate their financial condition accordingly. Freddie Mac, for example, recently presented investors with a dizzying array of statistics designed to demonstrate the soundness of their capital position. And analysts were understandably skeptical: " ‘We discount Freddie’s presentation …about how it can stay above regulatory capital minimums come hell or high water. Any number of assumptions in it are questionable,’ " offered one analyst. In short, it’s probably safe to say their condition is perilous, at best, and catastrophic, at worst.
  2. What’s at Stake?: The phrase too big to fail comes to mind. "With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending," argued The Economist. Suffice it to say that the US economy, in its current weakened state, simply could not tolerate the complete collapse of the mortgage giants, which together support more than $5 Trillion in mortgage securities. There are a few different groups of people who have a direct stake in what happens and will probably try to influence the process accordingly. First, there are shareholders and bondholders, who have invested and lent money, respectively to Fannie and Freddie. Meanwhile, there are speculators who have bought insurance (in the form of derivatives) against a potential bond default. In the event of a government bailout, bondholders would probably have to accept a "haircut" (discount) on bonds they own, while shareholders would probably be wiped out completely. The nature of the insurance derivatives, on the other hand, would entitle the speculators to a payout. Then, there are the company’s employees. The executive team of Fannie Mae has already turned-over, and it is believed that even the Boards of Directors would be replaced in the event of a full government takeover. This probably won’t provide much solace for rank-and-file employees, who face an uncertain future, and an Employee Stock Ownership Plan that is nearly worthless. We also need to consider American taxpayers, who will probably end up footing some portion of the bill, regardless of their level of complicity in inflating the housing bubble. Finally, there are other sectors of American capital markets, and even the broader international financial system, which would feel the ripple effects of a Fannie and Freddie collapse. Demand for certain types of securities, many of which are essential for the functioning of the economy in its certain form, would virtually dry up. Enter the Federal Government…
  3. Government Bailout: After the panic in July sent the share prices of Fannie and Freddie tumbling, the Federal government intervened. It was announced that the Fed would allow both firms to borrow from its "discount window" in order to buttress their capital positions and enable them to continue to provide liquidity in the mortgage markets. In addition, Congress passed legislation permitting the Federal government to further shore up the firms’ capital positions through the use of investments and loans. This piece of legislation set the stag for a more formal bailout, which was executed by the government on September 7. "Under the takeover, the government replaced the companies’ chief executives and shifted management control to their regulator, the Federal Housing Finance Agency, or FHFA. The government pledged to provide as much as $200 billion to help both firms ride through their expected mortgage-related losses." By placing the firms in a so-called conservatorship with the clear backing of the federal government, the Fed has changed the nature of the guarantee that is attached to their debt. Previously, it was assumed that the bonds issued by them enjoyed the implicit backing of the government; that guarantee is now explicit. Aside from this semantic change, the government bailout of Fannie and Freddie closely mirrors the rescue of Bear Stearns last March; shareholders will be left with next to nothing, while bondholders and counterparties are prrotected against the risk of default.
  4. No Long-Term Solution: Analysts agree that this plan represents a mere stopgap measure, intended to bide time until a more stable solution is drafted. In fact, "lawmakers and government officials said it could be a year or longer before the next Congress and the new president settle on a new role for the companies." Besides, a legislative solution could do more harm than good since the government stimulus plan that was hastily implemented in March probably contributed to the collapse of Fannie and Freddie: "lawmakers raised the limit on the size of home loans mortgage giants Fannie Mae and Freddie Mac can guarantee, from $417,000 to as high as $729,750 in some of the most expensive U.S. markets." In addition, the permission that Congress granted the Treasury Department in July to execute a complete takeover was hardly fair, rewarding investors and homeowners at the expense of taxpayers. Perhaps, then, it would be wise for Congress to remain on the sidelines going forward.
  5. Nationalization or Privatization?: "Fannie and Freddie were unique hybrids…they enjoyed the benefits of being publicly traded corporations with a government subsidy because of an implicit guarantee of their obligations." The ambiguity surrounding this structure is partially responsible for their spectacular collapse, and resolving the private/public dilemma will be part and parcel of their restoration. Favoring nationalization is the government bailout, itself, which proved that the banks simply are too big to be allowed to fail. Furthermore, the banks are mandated by law to facilitate affordable ownership, by providing liquidity in the secondary mortgage market. There are a few Congressman who are interested in reforming the banks so that they can fulfill this mission more efficiently. In addition, "Fannie Mae was [already a government organization] for the first 30 years of its life before President Lyndon B. Johnson sold it to the public to help pay for the Vietnam War." On the other hand, this debacle illustrates the high cost associated with guaranteeing the agencies’ debt, most of which will be born directly by taxpayers if the banks are nationalized. Also, it is only because of the government backing that Fannie and Freddie were able to borrow so cheaply, and expand their operations without expanding their respective capital bases. "Privatisation should then create a much wider range of competing entities. It is not entirely clear why the core business of the enterprises—providing guarantees for mainstream (not subprime) mortgages—needs government sponsorship."
  6. Liquidation: Perhaps, the government should simply allow nature to take its course. Or, better yet, perhaps, after nationalizing the two banks and restoring calm in the housing market, the government should force their liquidation or break-up. According to one "analyst, "Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon." One need look no further than Europe, points out another commentator, "where mortgage markets are completely private, but just as stable and efficient as in America. "
  7. Merger: "Given that the companies do pretty much the same thing – buying mortgages from banks, insuring them and creating mortgage-backed securities – there might be opportunities for savings if many of their managers and staff are, to put it politely, "redundant." Should the merged entity be called Freddie Mae or Fanny Mac?
  8. Debt Refinancing: As stated above, it will probably be months, perhaps even years, before a long-term plan for the beleaguered mortgage giants is settled upon. In the mean time, they must continue to maintain their day-to-day operations. "The two companies need to "refinance $225bn (£121bn) of debt by the end of September, a prospect which looks expensive after both were forced to offer record coupons on relatively small [recent] bond issues." In the last few weeks, the firms have issued a record $12 Billion worth of debt. While continued financing should not be too difficult, given the government bailout, it cannot be taken for granted. Some "investors are still stinging from the collapse in share price, and may be wary about buying bonds, given that the government guarantee may not last forever. In fact, one of the more recent financings was only possible because of "switching," in which buyers are permitted to swap old bonds for new ones, such that their net exposure is unchanged. There is particular concern that foreign buyers, which already own $1.5 Trillion worth of "quasi-governmental securities, will curtail their holdings. Even before the government bailout was announced, there was anecdotal evidence that foreign commercial banks had begun to reduce their exposure to the US real estate market by paring their holdings of mortgage-backed securities. In the future, such banks can be expected to err on the side of caution.
  9. Presidential Implications: Given that the government bailout in its current form is mainly a stopgap measure, the upcoming presidential election carries significant implications for the future of Fannie and Freddie. Historically, the Democratic party has maintained closer ties with the two organizations, compared to Republicans. This is a product both of political ideology and the companies’ targeted buying efforts. Surprisingly John McCain, the Republican Presidential nominee, has received $169,000 in "campaign contributions from individuals tied to one or both firms, compared to the $17,000 that Barack Obama, the Democratic Nominee, has grossed. Regardless, both candidates have voiced tentative support for the government bailout. Says "Obama: "Long term, what we have to do is go ahead and make a decision. If these public entities, then they have to get out of the profit-making business, and if they are private entities, then we don’t bail them out." To the chagrin of his fellow members of the "Republican Party, McCain was "quoted as follows: "Those institutions, Fannie and Freddie, have been responsible for millions of Americans being able to own their own homes, and they will not fail, we will not allow them to fail." The candidates have yet to provide specifics on how they would deal with the situation should they be elected. Based on historical precedent Obama could reasonably expected to nationalize both organizations, whereas pressure from his party could lead McCain to privatize them and leave their fate to the whims of the market.
  10. Implications for Investors/Homeowners: While the government bailout will enable Freddie and Fannie to stay afloat, both will probably be forced to curtail their role in the mortgage markets. As a result, home prices will continue to fall, and mortgage rates will continue to rise. As far as investors are concerned, there is always the potential to turn a profit. According to Barron’s, many institutional investors are making large bets that Fannie and Freddie will default, although the newspaper also notes that there are investors who believe the paranoia is overblown and are doubling down on their bets. The bonds of both organizations were trading at a discount prior to the government bailout as a result of cuts in their respective credit ratings. Perhaps of greater significance is the impact on the finances of the Federal government. The Treasury’s upfront liability for the bailout may reach $200 Billion, which could rise drastically if Fannie and Freddie are forced to write-down more of their more than $5 Trillion in mortgage securities. The Bush Administration has  managed to avoid accounting for this commitment. While the US has ultimately managed to maintain its AAA credit rating, "traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt."