The Treasury Department’s much-anticipated plan to prop up Fannie Mae and Freddie Mac has finally been (mostly) revealed. The move should help a bit to keep mortgage markets afloat, but if you’re not sure what all the fuss is about, this short primer should help.
What are Fannie and Freddie?
The financial world seems to have an insatiable appetite for cute nicknames. Nowhere is this more evident than in the names used to refer to the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). These organizations were among several public corporations described as “government-sponsored enterprises (GSEs).” GSEs are corporations established by Congress for the purpose of enhancing the flow of credit within the US economy. The GSEs are unique public/government hybrids; they have the implied backing of the federal government, but in most cases there’s no explicit guarantee of a GSE in the way that, say, a Treasury obligation is guaranteed. An exception to this is the Government National Mortgage Association (Ginnie Mae).
Originally created during Roosevelt’s New Deal as a purely governmental agency, in 1968 Fannie Mae was converted to its present status as a private corporation with shares traded on the stock market. It was joined by Freddie Mac in 1970. There’s an interesting piece in today’s New York Times by Floyd Norris on the complicated relationship between Fannie, Freddie, and the government. The two were intended to be privately-owned corporations that strengthened the housing industry by encouraging a steady flow of funding for mortgages. They had the implied support of the government, allowing them to issue bonds at low interest rates (because they were perceived as being low-risk, like Treasury bonds). At the same time it has always been denied that Fannie and Freddie’s debts were backed by the “full faith and credit” of the US government, but the markets always assumed an underlying “wink-wink” in these denials.
Fannie Mae is the largest buyer of mortgages in the country; it owns or guarantees about half of the US mortgage market. Fannie Mae and Freddie Mac (which also guarantees mortgages) together own about three quarters of the new mortgages made in the US. In the “old days,” most banks and savings and loans lent money to people in their local communities based on their creditworthiness and then held those loans among their assets. The funding for their loans came from local depositors – think of Jimmy Stewart’s banker character in “It’s a Wonderful Life.”
As financial markets have grown and become more complex, it’s been possible to expand mortgage lending by combining large numbers of mortgages into packages and selling them to investors, who then collect the income stream. Fannie Mae and Freddie Mac bought or guaranteed loans made by banks, collecting fees from the banks in return for providing a ready market for their mortgages. With their implied governmental status, the GSEs borrowed more and more money to enable them to acquire new mortgages.
Why Fannie and Freddie Needed a Bailout
Although some smaller banks continue to make loans that are kept on their books, the vast majority of mortgages made today enter the secondary mortgage markets by being pooled together (“bundled”) into securities. As everyone now knows, over the last few years lenders were so eager to lend money that they made loans to borrowers whose creditworthiness was unknown to them, or to people who were borrowing beyond their means. Most of these dodgy loans were “securitized.” When housing equity was growing, increasing equity was like a narcotic that kept everyone happy, but stupid. Eventually, the housing markets quit booming, and bad loans began to be seen for what they were, especially as they went into default.
The national mortgage default rate is now above 9%. Banks and other holder of tainted loans – especially Freddie and Fannie – have experienced big losses from mortgage defaults. Many loans that haven’t failed are considered less valuable because they may yet default, so holders of the debts have had to mark down the value of their assets.
Buyers for mortgage-backed securities demand much higher rates of return because of the greater implied risk. Banks have become unwilling to make loans and keep them on their own books because they already hold too many questionable loans. Fannie and Freddie, because they’re already financially exposed to the worst mortgages, are hobbled in their ability to purchase new loans. They’ve raised their fees for taking on new loans, making banks even more reluctant to originate new mortgages.
A significant number of the mortgages held or guaranteed by the two firms now appear likely to enter default. Former Federal Reserve Bank of St. Louis President William Poole has estimated that the two companies could experience losses as large as 5% of their obligations, amounting to a tab of $300 billion.
So far the two have experienced losses of about $14 billion over the last year; the likelihood of future losses raises questions about their viability. Financial markets work when people feel good about how things are going, and that isn’t the case right now. A default from Freddie or Fannie, as the largest holders of secondary mortgages in the country, would have destroyed what little confidence there is remaining in US mortgage markets.
With investment banks having their own problems lately, the chance of help for the two agencies from private sources was nil. Since everyone has always assumed that Fannie and Freddie would be bailed out by the government in the event of a crisis, it was inevitable that the present circumstances would require government intervention. In fact, anything less would have probably caused a panic. The Treasury Department announced in July that it was working on a solution to Fannie and Freddie’s problems, and the markets have been waiting for the other shoe to drop.
Both companies have been placed under the conservatorship of the Federal Housing Finance Agency, which previously regulated the two companies and now has management control over them. Both companies can now borrow money directly from the Treasury to cover their losses.
In return, each company will issue $1 billion in preferred shares yielding 10%, to be purchased by the Treasury. The Treasury also receives warrants, which are options to buy new preferred shares. The new shares may be issued at a level that eventually reaches almost 80% of the stock equity in each company. Future infusions of capital to keep the companies afloat will result in issuance of new preferred shares to the Treasury. These are “senior preferred shares,” meaning that they have the first right to receive dividends from the companies. Senior management at the two firms will receive some lovely parting gifts.
The control of most of the secondary market for home mortgages in the US is now held directly by the government. The two companies are technically still publicly owned, but there’s no more need for winking.
What Have We Learned?
As Floyd Norris observes in his Times article, it’s still true that no man can serve two masters (Matthew 6:24). The implied government guarantee behind FNMA and FHLMC encouraged the management of the corporations to take too much risk, with the outcome that both the shareholders and the federal government must bear the consequences. It remains to be seen what will the two corporations will evolve into, but it seems unlikely that either will return to its former fully-private status in the future.
The Freddie-Fannie saga should be a cautionary tale for stock investors. Although neither company has entered bankruptcy, the stockholders of the two corporations will experience significant losses that will not go away anytime soon. As new preferred stock is issued to the Treasury, the percentage of ownership of the corporations represented by the existing stock will continue to shrink. In the worst case, if the Treasury ends up exercising its options for the full 79.9% of ownership, each share held by current stockholders will represent 1/5 of the ownership than it does today. It seems likely that the Treasury will end up exercising most or all of its warrants, so the stock price is plunging to reflect that expectation. As I write, Fannie Mae’s common stock price is down today by 83% and Freddie’s is down by 80%. This, by the way, is still is not as bad as what happens when a company goes bankrupt; then, stockholders’ holdings often go to zero.
Interestingly, some big-name money managers have been burned by the takeover plan. Bill Miller of Legg Mason Capital Management has been building his stake in Freddie Mac under the assumption that things would work out; his fund is estimated to own 12% of the outstanding FHLMC shares. Miller and others apparently believed that the two companies would be bailed out in a manner that would preserve the existing shareholders. They made a big bet and lost.
It’s not yet certain what the impact of the takeover will be on holders of the companies’ preferred stock. Any profits that the companies manage to make, if they are paid out in dividends, will go first to the Treasury’s senior preferred shares. Preferred shareholders have first dibs on dividends, but they aren’t guaranteed. The likelihood is that no dividends will be paid to other preferred shareholders (much less to holders of common stock) for a long time. This makes those shares less valuable. As it happens, there are a great many commercial banks and savings and loans that hold preferred shares in Fannie Mae and Freddie Mac. Today’s Wall Street Journal reports that there are at least 17 banks that hold 10% or more of their tier 1 capital in shares of the two companies. For example, Philadelphia-based Sovereign Bancorp is believed to hold 13% of its tangible capital in the preferred stock of the two GSEs. The government will have to figure a way to protect the interests of these banks; it wouldn’t be a good thing for the government’s bailout of Fannie Mae and Freddie Mac to be seen as the proximate cause of any bank failures. It’s likely that the Treasury department will end up buying some of those preferred shares from the banks themselves to help them pretty up their balance sheets.
Banks and investors that hold Fannie and Freddie bonds were spared in this plan, but that did seem kind of likely. If one of the companies had been forced into bankruptcy, the value of their debts would have plummeted. Now that the Treasury stands behind the FNMA and FHLMC, holders of their debt can breathe easy.
If you’re interested in following the development of this saga, a good place will likely be the Calculated Risk blog, which does a good job of keeping abreast of the Fannie and Freddie story.