The Fannie and Freddie Conundru

1 February 2010

Within the next two weeks the White House is expected to release its blueprint on what to do with America’s money-losing - but much needed -Congressionally chartered mortgage giants, Fannie Mae and Freddie Mac.

Wards of the federal government since their takeover in September 2008, Fannie and Freddie today provide the liquidity for 70% of all new originations in the US.

The balance is provided by another US agency, the Government National Mortgage Association.

Fannie and Freddie’s mission, as always, is to buy mortgages from banks, savings and loans, non-bank lenders and credit unions.

By doing so they provide fresh cash, which is circulated throughout the financial system in the form of new loans. Without them the amount of money available for new mortgages would be chopped in half.

But what do you do with two behemoths that have already cost the Treasury $100bn and are likely to cost another $100bn? Kill them outright or keep them going, praying that in time they’ll turn a profit? And there in lies the dilemma.

First, let’s state what might not seem so obvious: Fannie and Freddie are really giant savings and loan institutions. They hold liabilities and assets. Instead of using deposits (like the old building and loans used to do) they tap the capital money markets using short and long-term debt.

Most of their assets aren’t whole loans, but mortgage-securities backed by residential whole loans. Together, they have $1.6 trillion of on-balance sheet assets and off-balance sheet guarantees of $3.6 trillion for a total exposure of $5.2 trillion.

They account for 55% of all outstanding (yet to be repaid) home loans in America.

And even though both operate under federal conservatorships, with Treasury pumping money into them to keep their net worth positions north of zero, Uncle Sam has yet - as a technical matter - to put his full faith and credit sticker on them.

It seems odd that the US government has rescued them without explicitly backing their bonds but, believe it or not, that’s exactly what has happened.

Currently, the Federal Reserve and Treasury are the majority buyers of all their new obligations - but supposedly the two will stop gobbling up their obligations come March 31.

Who will buy their bonds then? Answer: institutional investors in the private market (pension funds, insurance companies, banks), the same folks who did so before Uncle Sam seized control of them, realising that without federal aid they’d go bust.

But will these private investors return, and if so, at what price? All this translates into a nifty little problem: how much yield will Fannie and Freddie have to pay to entice private sector participants back?

To novices, the full faith and credit issue might seem silly but it’s not.

If the US government says explicitly that it stands behind their debt obligations that means Uncle Sam’s debt load just increased by $5.2 trillion.

And as most of us realise - except, perhaps, Nobel Prize winner Paul Krugman - the US has much too large a debt load.

Then again, as Krugman has argued, our debt problem is secondary to turning around the US economy.

Krugman is much smarter than me and I hope that ultimately he’s right. As for Fannie and Freddie, anyone who thinks they should be shot in the head doesn’t understand how the US mortgage market functions.

They cannot be shut down and liquidated for this one reason: If they disappeared overnight, which institutions would fund mortgage demand in America? Wells Fargo? Bank of America? JPMorgan Chase?

I’m not talking about merely originating loans - all three already do that, with a combined market share north of 55%. But where would all those freshly originated loans reside? On the balance sheet of the big three? Or would they turn around and securitise residential loans using the private label mortgage backed securities market?

Oh, that’s right, there is no private label MBS market any more.

It’s Fannie, Freddie or the aforementioned GNMA, but it’s unlikely Fannie and Freddie actually have the full faith and credit behind their obligations.

Let me put it in plain language: there is no easy solution to filling the void that would be created if Fannie and Freddie got shot in the head.

The Federal Home Loan Bank system, a cooperative of 12 Fannie/Freddie-like government chartered banks, have financial problems of their own. The FHLBs might be a start, but let’s first ask how Fannie and Freddie got into trouble in the first place.

The answer: they bought $400 billion in sub-prime loans or securities without paying much attention to credit quality. Who sold them this crap?

The ’Masters of the Universe’ on Wall Street: Bear Stearns, Merrill Lynch, Lehman Brothers. Take your pick.

Why didn’t we know they owned so much crap in the first place? Well, we knew bits and pieces of the story, but for years Fannie and Freddie had a weak and under-funded regulator with all the punching power of a bantam weight. Plus, any time Fannie and Freddie didn’t want something to happen that would hurt their business, they poured money into the coffers of politicians on Capital Hill (both parties) who did their bidding.

But does that mean the Fannie/Freddie model is broken? I’m not sure. An argument can be made for their survival as closely regulated mortgage utilities which, by law, are barred from lobbying government officials and regulators. (To paraphrase Shakespeare: “First, we kill all the lobbyists”.)

It probably would be a mistake to scrap the model entirely. It serves a function: a balance sheet on which we, as a nation, can place long-term mortgages which are funded by (gulp) short and long-term liabilities.

As for the full faith and credit issue and making their obligations that of the US government, I’m not so certain. But I do know one thing: $5.2 trillion in mortgages is a lot of money. All that water has to go some place.

Paul Muolo is executive editor of National Mortgage News

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