The ABCs of the Fannie Mae / Freddie Mac Problems

A.

First of all, who are Fannie Mae and Freddie Mac?

Fannie Mae: Is the nickname for the Federal National Mortgage Association (FNM)

and

Freddie Mac: Is the nickname for the Federal Home Mortgage Corporation (FRE).

Collectively, they are know as GSEs or Government Sponsored Enterprises and their job is to provide local banks and mortgage lenders with liquidity to finance home mortgages.

These GSEs are not government owned, only government sponsored. This means that they are privately held and operated by shareholders but receive a line of credit from the US Treasury and an exemption from taxes. Fannie was privatized by Lyndon B. Johnson in 1968 to remove it from the national budget. Freddie was created in 1970 to prevent monopolization of the secondary mortgage market by Fannie. Both GSEs are exempt from SEC oversight.

Fannie Mae and Freddie Mac are very important entities within the US economy. They guarantee approximately $ 6 trillion in outstanding home loans, and service 50 million mortgage customers. The value of their loans is equal to 2/3 of the current national debt!

With their triple A credit ratings and a $2.5 billion credit line with the Treasury, many investors have long considered Fannie and Freddie the safest of the safe.

B.

So What’s the Problem?

As owners of the lion share of mortgages, Fannie and Freddie have not been immune to the subprime mortgage crisis. However unlike the other Fortune 500 companies, Fannie and Freddie are not forced to disclose their financial difficulties. Investors fear that they will suffer more losses than the $11 billion that has already been reported.

Not too long ago, the Justice Department and the SEC discovered accounting errors in the amount of $4.5 to $4.7 billion. The current fear is that the sheer size of Fannie and Freddie’s potential losses eclipses their lifeline.

Fannie and Freddie’s shares have fallen to the lowest levels in 19 years. Speculators believe that not only could they be insolvent, but based upon the comments from US Treasury Secretary Paulson and President Bush, the US government does not think that a bailout is needed.

Yet liquidity problems can be compounded by market fears. Remember how Bear Stearns’ credit lines were all pulled on speculation that the bank would go under, which of course exacerbated their demise. Selling of government bonds can lead to higher bond yields and pricier borrowing costs for the GSEs.

C.

Too Big to Fail?

The biggest question in the financial markets right now is whether or not Fannie and Freddie are too big to fail. I certainly think so. If the government stepped in to prevent the Bear Stearns meltdown from crushing the market, they will step in to prevent a collapse in Fannie Mae and Freddie Mac because if these two GSEs fail, Americans will have to shoulder the burden. Fed Chairman Ben Bernanke has already announced that the GSEs can have access to the discount window, which would allow them to borrow money directly from the Federal Reserve rather than the markets.

Bernanke Opens the Discount Window, But Will that Be Enough?

If Fannie and Freddie’s problems are not solved and they still have difficulties borrowing, this means that they will have difficulties lending, which is something that the US government can not gamble with at this moment.

It would send a much stronger message to the markets if the US government:

1. Guaranteed Fannie and Freddie’s loans
2. Nationalized the GSEs
3. Infused government funds into Fannie and Freddie (equity investment)
4. Encourage further investments from private investors

China, Japan, the Cayman Islands, Luxembourg and Belgium are the top 5 foreign holders of Fannie and Freddie’s debt.

For the currency market, it is a lose-lose situation for the US dollar. Further problems at Fannie and Freddie would push stocks lower once again, which would trigger another flight to safety out of US dollars. A bailout would essentially double the public debt, risking a downgrade in the US credit rating.

Comments

[borisb:]

Too big to rescue?

2008 Jul 11 10:53 PM

[Greg Pinelli:]

Brilliant advocate of the free market! Not... You mean, of course, too big to allow to fail. Since the largest holders of these two imploding debt machines are other sovereign nations then let them come up with a plan.
Luxembourg and the Caymans are rolling in it...lots of that Middle East oil money we've been shoveling at dressed up tribal nobodies for years!
Also..as long as I'm ripping this inept 8th grade level term paper...what does SEC oversight have to do with anything?? Citi, Wachovia, et al (that means "and others" Kathy)..are all under SEC "watchdogs...."
As for Abolish the Fed idiots...you nimrods should hook up with the silver conspiracy dudes..between the two groups you are bound to have someone with a normal IQ.

2008 Jul 12 12:51 AM

[Taxpayer:]

And when did it become the government's job to send a strong "message to the markets"?

For crying out loud, adult people made bad bets (like buying garbage from Fannie). Don't have me pay for their follies.

The article failed to mention Fannie's mission, which is to provide "stability, liquidity, and affordability to the nation's housing finance system under all economic conditions. "

Isn't it terribly clear that they have completely failed that mission? They should be abolished (or rather, not saved).

2008 Jul 12 01:59 AM

[pochovilla:]

It takes the whole alphabet to describe the problems with Freddie and Fannie. ABC is the condensed version.

2008 Jul 12 08:49 AM

[fatcat:]

what happened to the days when a local banker would make a homeloan based on credit and value..payments would go to the bank and the bankers knew the customer and the property.Really,quite a simple business.Fannie would take certain properties if some standards were met,and everybody was pretty happy.If there was a default,another family would soon be in the house and the cycle would start again..

Who said the 60s were turbulant years?

2008 Jul 12 12:27 PM

[Peter Lynch:]

>>>A bailout would essentially double the public debt, risking a downgrade in the US credit rating.<<<

Guaranteeing a debt is very different from acutally issuing a debt......please be more responsible in your writing.

2008 Jul 12 12:57 PM

[User 225386:]

I'd like to know why no one is looking at the culpability of Congress itself, in particular Barney Frank who continued to support Fannie and its leadership, in particular Franklin Raines. How many hundreds of millions in bonuses and stock options did this management walk away with while creating this mess. Kozlowski is in jail for an expensive shower curtain and he didn't cost the taxpayers, or the financial markets a thing. Why aren't Raines et al right behind him? Where is the outrage?

2008 Jul 12 01:54 PM

[sr9web:]

Bleh! It's not as bad as some people think. The Treasury line of credit can be substantially increased and an asset recovery agency will be formed to sell any bad assets that FRE/FNM ends up with beyond what's tolerable. Worst case scenario is that the FRE/FNM dividend get cut sharply. If not, there would be complaints that Fed rescue is fattening shareholders with big dividends. FRE/FNM are not going to be liquidated, nor will their stock got to zero. All of a sudden their financial status is a surprise? Don't be silly, as GSE's, they've been closely monitored since before the beginning of this crisis. They could have easily stopped buy the mortgage flow of the last 2-3 years (which i where all the killer junk is). Why didn't they? Because they are GSE's and have a mandate to buy! Even in a worst case scenario, with whatever concessions are made by FRE/FNM, there will be no more than a 50% dilution of the common. Why do I say that? Because never again will any smart money support any GSE of this type if the US bails on the FRE/FNM common holders. They are 95% owned by big institutions - mostly mutual funds on behalf of small investors. You think that Congress is going to let millions of Mom & Pops get killed financially over this? No way! It was the regulators job to be prepared for the current market conditions, which for trained regulators is a foreseeable event. Those regulators have a fiduciary duty to the public - which includes the common shareholders. If FRE/FNM fail, it's the regulators fault. I would go so far as to say that a Govt takeover of FRE/FNM would trigger "takings clause" lawsuits. The Government can't lawfully put private capital in a catch 22 and then seize it for no value. The common holders of FRE/FNM only put up their capital because they take it on faith that the regulators will see to it that the public mission of the GSEs is carried out soundly. I am absolutely certain the Govt is liable to the commons shareholders if these GSEs are pushed by regulators into insolvency, if they are not backstopped by the Feds or if they are seized ("nationalized"). The current panic in FRE/FNM has been major short seller attack - nothing more.

2008 Jul 12 01:58 PM

[Davep:]

I disagree.
Most common stock shareholders have already lost huge amount of invested money in FRE/FNM. It would be pointless to save them now because FRE/FNM would probably and gradually continue to lose shareholders' values possibly reaching close to nil without a miracle. It's point of whether nationalize it now to quickly ease the biggest current mortgage crisis going on right now or make it a slow painful path down the road. I feel for the shareholders but looking at the big picture, would you save them first while the whole economy is in a mess? Common shareholders should be seen as just public investors with high risk in today's market.
I'm not saying that the fed taking 'em over is the only solution but no one may not be able to protect the shareholders value when the situation gets worse.

2008 Jul 12 02:47 PM

[Did U Think...:]

Fannie and Freddie are the lapdogs of the illuminati who actually want the US middle class wiped out. We currently have too much control over our own lives and ony the distruction of our wealth and the subsequent police state needed to keep the peace will change that. America has been sheeplized over the past 3 decades while the money supply has been debased at a frightening rate due to lack of limits on leverage in our ficticious fractional reserve system. The housing market was simply a convenient asset class to soak up all the excess credit creation that has occurred while banker elitists collected record payouts.

This is not about making mistakes people. Do you think that we common people are the only one who could predict the outcome? They knew it was coming and they kept hard at it until the end. The fix was put in. The order was given. Wipe out the US middel class to make way for the NAU.

2008 Jul 12 03:26 PM

[ari5000:]

If the Fed 'guarantees' the debt -- then they are backing up $5 trillion in debt -- of which quite a good chunk will be written off. Probably not the whole thing (homes don't got to zero) but even a 20% drop is another trillion added to national debt.

This is probably the best choice. FNM/FRE should definitely trade down to ZERO. No way they will get a dime. Otherwise home market will freeze completely.

2008 Jul 12 03:48 PM

[Stuman:]

"It would send a much stronger message to the markets if the US government Nationalized the GSEs"

you are an idiot. please visit a neurologist for a brain scan.

2008 Jul 12 04:25 PM

[houseofcards:]

It is a miracle that US debt is not junk rated. It shows, muscle power wins.

2008 Jul 12 04:54 PM

[Celcius:]

This entire problem is the result of the Fed's failure to raise interest rates to cool off the housing bubble when housing prices were growing 1% to 2% faster then the total economy. Greenspan didn't raise rates to slow the tech bubble, so it burst and capital moved to property. The property bubble burst and now we have moved to commodities. Investing has turned into a follow the pack mentality which is creating one bubble after another. The Fed needs to focus on inflation only and in any form - stock, bond, property, commodity, etc. and raise interest rates to control its growth. The Fed has been too concerned about short-term jobs numbers than the long-term economic health of the economy. The SEC also needs to step up and regulate financial vehicles like SIV's & CDO's, and prevent new financial vehicles from being offered until the SEC can access the market risk and establish conservative capital requirements. Our total economy if far to leveraged which makes it very brittle during a contraction. In the end it is the tax payer who will suffer to repay the cost of market speculation on leveraged capital. We need leverage ratio caps from 1:2 to 1:5 on all purchases - stocks, bonds, and commodities. This also would significantly reduce price inflation.

2008 Jul 12 06:33 PM

[kahunabear:]

Neither the stockholders or bond holders should be bailed out. The bonds have no guarantee. And if it is "implied", it shouldn't be.

The very best thing for the mortgage market is to let the buyers of the bonds feel the pain of taking on risky mortgage backed securities. Thisis the only way to prevent this rapant "risk free" speculation in the future. Letting the bond holders earn a return in line with the return that the actual mortgages produce will cause future mortgages and mortgage bonds to be priced appropriately by the market.

Otherwise, we will end up right back in another bubble where the robber barrons rape the taxpayer by taking ridiculous risks to line their pocket books knowing they can pawn off any losses to the masses.

This is exactly what is wrong with American crony capitalisim. Alas, my idea will never happen. We are doomed to a future of pillaging and will eventually end up as a Banana Republic. Want to know why oil is so high? It is a heck of a lot more reliable currency and store of value than the buck. They aren't making any more of it. On the other hand, their is an unlimitled supply of Bernanke bucks.

2008 Jul 12 08:34 PM

[LoveShorting:]

Ari 5000 - - Thank you for the simple, clear message I needed to hear: "trade to zero" ... sounds like a safe short.... It helps that Barrons agrees with you.
"Did U Think" - - Thanks for the most interesting remarks. What does NAU stand for?
Anyone know who is weaker, FNM or FRE ??? So tired of hearing them mentioned in the same breath when they have shown some differences in trading and they have differences in fundamentals.

2008 Jul 12 10:13 PM

[kahunabear:]

LoveShorting - NAU = North American Union
en.wikipedia.org/wiki/...

2008 Jul 12 10:35 PM

[Kunst:]

The root of this whole mess: decades of deficit spending, resulting in creation of money through debt, overconsumption, and dilution of the dollar.

2008 Jul 13 01:43 AM

[guliamo:]

Here's another reason for the fall.. G-R-E-E-D !!

2008 Jul 13 06:09 AM

[steveballmer:]

oops!

I thought you were talking about apple, sorry.

2008 Jul 13 12:36 PM

[CaptBob:]

Please excuse my laziness: Third F&F article I've read, third one short of solutions--so 2nd time I've moved mine over. First one was the original--but- "if the shoe fits"--take the easy road, No?

The Investment bank of last resort is the Fed.
But they must have a good "Humanitarian & quality reason to appease Congress on a move of this magnitude. Bailing bankers with tax dollars is getting unpalatable.

The poison pill in the whole mess are sub-prime mortgages. They were created by greedy bankers but now they bite all who touch them, bankers and unsophisticated/innoce... homeowners alike.

I believe Congress will create a "Homeowner safety net". The houses are built, bought and paid for. To toss families in the street and create deteriorating, vandalized, vacants, exacerbates the loss. At best they are auctioned for 30% of value, depressing 100% of the market Nationwide.

This "safety net" will funnel the loss difference from the Fed to Fakee & Foolie to take over and rewrite the mortgages in a manner the occupants can afford-(with pain attached). The phonies-(application liars and speculators , for resale) will be sold off in a trickle the market can absorb.

This of course will require Zimbabwe Bennie to go for an advanced course in turbo charging a printing press. And will result in the dollar going from medium/rare to well done in the cooked dept.

But no matter how you turn it, there are only fiat dollars in the lifeguard tower. Might as well make some political hay out of it, that will fool most of the people most of the time. And give the other big banks--(their buddies) a chance at a Phoenix resurrection, by unloading a PORTION of their stink on Fric & Frack. With their books who's counting??

2008 Jul 13 12:45 PM

[Bob Gary:]

I think there will be a bailout. Paulson wasn't stern enough in his stance. I was just reading this piece and I tend to agree. There was another article up on SA today that summarized this well. Time will tell.

2008 Jul 13 02:50 PM

[Did U Think...:]

Who cares what they do? The fed will not be able to save 5 trillion worth of bad debt. Then the 2.5 trillion in credit card debt will fail. Then the 700 trillion in derivitives will fail. All of this will put us in such a state of panic and poverty that the majority of americans (who mainly belong to the "give me something for nothing crowd" which the socialist gov't has engineered) will BEG for the NAU before this is over. It will be pitched as a fix for all the problems but the only thing that will be "pitched" will be our constitution, our liberties, our privacy, and our personal security.

There is no accident here. The Elitist DEMs and GOPs are one in the same anymore - they have become the Central Leviathan Party AKA The Uniparty. Their real goal is to create the new serfdom - elitists profiting from the labor of the masses. This can only happen if we are convinced that we should live within their "Matrix" otherwise there will be civil war. Thus, they must convince us that we deserve the new system and that we are somehow benefitting from it. That's why they want socialism. A sheeple that eats from the gov't trough is unlikely to need a rifle butt upside the head in order to stay within the gov't drawn lines. When everyone is on the new "working welfare" there can not be any complaining. Welfare is simply a modern version of sharecropping. Hoover dam was built with paid slave labor. But it could never have been done without impoverishing the worker class first via the great depression which was 100% a product of the federal reserve. The men working on hoover thought themselves lucky to have a wage slave, dangerous job. They would do ANYTHING to support their familes in the economic aftermath of the depression.

When it happens, do not question why. You will know why and who and how. The only open questions are when and where. And with every week that goes by and we see more and more financial bombs dropping I would say that "when" is sooner than most people can fathom.

2008 Jul 14 02:53 AM

[Kinabalu:]

I can't wait til the Bush adminitration is gone. Obama's fiscal conservatism will restore faith in the GSEs and the American $. Maybe he'll pick Charles Schumer for VP.

2008 Jul 14 02:30 PM