Fannie and Freddie teeter on the brink

28 June 2010 | By Paul Muolo

Fannie Mae and Freddie Mac - the congressionally-chartered mortgage giants that have been wards of the US government for almost 22 months - are done for. Stick a fork in them and close the barbecue lid. Their chances of surviving and returning to the glory days of record profits are zero.

Who says so? Their regulator. Two weeks ago the Federal Housing Finance Agency decided to pull their shares off the New York Stock Exchange and place them on the Over-The-Counter Bulletin Board market. This is like pulling a soccer team out of the World Cup so they can play an art school pick-up game.

The OTC market is where companies go to die or rehabilitate themselves, although most succumb to the former.

Now don’t get me wrong. These two government-sponsored enterprises don’t have a bright future. They are in conservatorship, continue to lose money and Republicans and Democrats alike continue to lay blame for the entire US housing bubble at their doors, which is both wrong and ignorant.

As I’ve pointed out before, Fannie and Freddie did not cause the US housing bubble and subsequent sub-prime crisis although it can be argued they played an important supporting role by being buyers of sub-prime bonds created by Wall Street.

Why did the regulator in charge of both Fannie and Freddie pull them off the NYSE? Good question

Some analysts and industry historians argue that if they had not been there to buy sub-prime mortgage bonds the asset-backed securities market would not have grown so large and the incentive to create risky loans and package them into securities would have been nil.

Finance professors, journalists, elected officials, analysts and anyone else with a dog in this fight will argue about their role for decades to come.

To me, the main culprit of the sub-prime mess was Wall Street. If firms such as Bear Stearns, Lehman Brothers and Merrill Lynch hadn’t lent money to non-bank sub-prime lenders and securitised their Ato D loans, there would have been no liquidity and therefore no market. End of story.

But getting back to Fannie and Freddie, to date the US Treasury has pumped $140bn of taxpayers’ money into the two, allowing them to maintain a positive net worth position.

So why would these two gorillas need a positive net worth? Answer - as a technical matter the guarantee on their bonds is still implicit and no investor in their right mind would buy their debts and mortgage-backed securities if they were in the red.

Together, the two hold $1.6trillion of mortgages or MBS, and guarantee another $3.9trillion in loans. Put another way, $5.2trillion of the $9.8trillion in outstanding US mortgages are on their tab.

Fannie and Freddie are the market so why did their chief regulator at the FHFA, director Ed DeMarco, pull them off the NYSE? Good question. DeMarco isn’t talking, although on the morning of his announcement he issued a statement saying the decision to delist “does not constitute any reflection on either enterprise’s current performance or future direction”. Yeah, right.

NYSE rules stipulate that any company traded on the market must maintain a minimum average share price of $1 for 30 days. If a firm goes under that threshold it can appeal and be given a quarter or two to get into compliance.

But Freddie was in compliance and Fannie had only just gone out of compliance so why did DeMarco make the call? Nobody knows and like I say, he’s not talking.

Meanwhile, early next year the White House is expected to unveil its plan to restructure the two entities. The early word is that the president’s team is clueless on what to do.

Many believe Fannie and Freddie will be combined into a single company with their current holdings - the aforementioned $1.6trillion - being allowed to run off over time. Their guarantees will remain and new ones will be written but at the moment nobody knows what it will cost lenders for this insurance and how much will have to be borne by consumers.

The bottom line is this - $1.6trillion is a lot of balance sheet to replace and few have a clear idea on what type of financial institutions, if any, will step in to fill the void. That’s what you call a conundrum.

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