How Do We Get Out of the Mess with Fannie and Freddie?

How did we get into this mess, and how do we get out of it?

First, a little background:

Both Freddie (FRE) and Fannie (FNM) were initially created by the U.S. Congress with the goal of expanding the residential mortgage market. They are for this reason referred to as "government-sponsored enterprises," or GSEs, even though both eventually were converted into private companies for which there is today no explicit government guarantee of their debt....

After a homeowner has borrowed money to buy a home, the original lender likely resold that loan to Fannie or Freddie. The GSE in turn collected some of those mortgages in a pool which was sold in the form of mortgage-backed securities [MBS] to private investors, for which the GSEs collect a fee in exchange for guaranteeing payment on the MBS. Other mortgages purchased by the GSE are held directly by the GSE for its own investment portfolio. The GSEs obtained the funds for these investments primarily with money borrowed directly from private investors, which instruments are referred to as "agency debt."

The table below provides a simplified balance sheet for Freddie Mac. Most of the nearly $800 billion in assets held by Freddie as of the end of 2007 consisted of mortgage loans or securities based on mortgages. The company acquired the resources to buy these assets primarily by borrowing, with outstanding debt as of the end of 2007 of $738.6 billion.

The key item on the liabilities side of the balance sheet is stockholders' equity, which represents the capital raised by Freddie through direct sales of stock and cumulative retained earnings. This equity provides a cushion against possible losses on any of its assets, in that the first $26.7 billion in losses would come out of the company's original capital, with creditors losing nothing. That cushion, however, would only cover losses that were less than 26.7/794.4 = 3.4% of the assets.

Simplified balance sheet for Freddie Mac, in billions of dollars. Data source: 2007 Annual Report, p. 168.

Assets		Liabilities
mortgages	80.0	debt	738.6
securities	629.8	other liabilities	29.1
other assets	84.6	stockholder equity	26.7
total assets	794.4	total liabilities	794.4

Fannie's 2007 stockholders' equity came to 5.0% of assets.

Simplified balance sheet for Fannie Mae, in billions of dollars. Data source: 2007 Annual Report, p. 102.

Assets		Liabilities
mortgages	403.5	debt	796.3
securities	406.6	other liabilities	42.2
other assets	72.5	stockholder equity	44.0
total assets	882.6	total liabilities	882.6

These balance sheets leave out the mortgage-backed securities that the enterprises created and sold directly to outside investors, for which the enterprises have issued off-balance-sheet guarantees for payment. The OFHEO 2008 Annual Report to Congress states that Freddie had sold $1,381.9 billion in MBS and Fannie $2,118.9 billion.

If you add together the mortgages retained outright by Fannie and Freddie (either as whole loans or MBS) plus the MBS that they have sold to others and offer a guarantee for payment, the OFHEO calculates a total "book of business" for the two enterprises of $4,934.4 billion as of the end of 2007, slightly less than the total publicly held debt of the U.S. government. Fannie and Freddie's combined stockholders' equity amounts to 1.4% of their total book of business.

Fannie and Freddie borrowed the funds with which this empire was leveraged at terms nearly as favorable as those for the Treasury itself. Unquestionably a key reason that investors have received agency debt so warmly over the years, and treated the guarantees as credible, was the assumption that Fannie and Freddie were too big for the federal government to allow to fail.

This creates an unambiguous concern of moral hazard. When investors assume that the government will cover their losses, the result is a higher volume of funds flowing into the GSEs than is socially desirable. The upside goes to the lender, the downside is supposedly picked up by the government, and the result is the enterprise is expanded to a greater level of risk than makes economic sense.

Source: Lockhart (2008).

The GSEs' book of business represented 25% of outstanding residential mortgage debt in 1990 but comes to 41.4% today. It is hard to avoid the conclusion that these moral hazard distortions were one factor that contributed to the rapid expansion of mortgage debt over the last decade and attendant excessive price appreciation and risk taking. Granted, the real excesses, such as the subprime loans that everybody was initially discussing, came from MBS created by private institutions rather than the GSEs. But the stock market seems to be declaring pretty loud and clear this week that risks associated with enterprise assets are significant.

 

Source: Yahoo Finance.

 

Source: Yahoo Finance.

So where do we go from here? If we indeed reach a point where one or both of the GSEs can no longer honor its commitments, the Treasury's contingency plan might follow the Bear Stearns philosophy of leaving shareholders nothing but protecting creditors and counterparties fully. But if the U.S. Treasury ends up assuming a significant burden, this would at a minimum raise the logistical question of how taxes are going to be raised to cover the costs. One strategy that holds some appeal would be to let the burden of the tax fall entirely on the creditors and counterparties themselves-- in other words, no government bailout at all-- as argued by Nouriel Roubini:

[N]otice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency-- as of now and in the worst scenario of $200 to $300 billion-- the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or-- for unchanged face value-- a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

So what's wrong with that idea? The overriding concern in dealing with the current mess is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. In addition, I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.

The principle of "make those who caused the problem pay" has a lot of visceral appeal. But the principle of "don't impose severe and gratuitous extra costs on those who had no role in causing the problem" -- in other words, don't make the housing depression much more severe just to teach somebody a lesson -- has to be the basis for our policy decisions.

My recommendation would therefore be for a managed bailout in which the stockholders, creditors and taxpayers jointly share the bill.

And now we can haggle about the price.

Comments

[MohideenIbramsha]

What about the home owner? Consider a home owner who bought a house under 30-year mortgage in 2005. With property values falling, and the cost of living increasing, the mortgage payments cause pain.

While buying the home a person is allowed to commit up to 40% of his income. With the increased cost of living, the other 60% grows to eat away more, possibly 70% of the income. The net result is the home owner eventually defaults on the mortgage payments.

We recommend that the defaulted mortgage payments be borne by the stockholders, creditors, and tax payers for those defaulting home owners with documentary support. The documents show that they have no cushion in the other 60% of their income and thus they have no option but to reduce their mortgage commitments.

[johnaf]

The piece missing in all this how does the Mortgage Insurance on those loans over 80% loan to value play out. Even some subprime loans had PMI protection against default even though the borrower was not charged for it like on a prime loan. I don't see any facts which include how the PMI payments affect the overall picture. Therefore any write downs should be less because of the PMI reimbersment. It is my belief that the mortgage backers are waiting for the goverment to come to thier aid and I think the govrment should stay out of it since the problem was caused by greed on the part of the mortgage lenders. Had the lenders made mortgages using prudent lending practices we would not be in this mess.

[Crocodilian]

"This creates an unambiguous concern of moral hazard."

And how. "Moral hazard" is one of the great concepts of behavioral finance. The extent to which a guarantee changes behavior is often underappreciated, even by savvy folks. In the case of Agency paper, the guarantees allowed risk to move into many parts of the financial system where it ought not have been, and would not have otherwise been permitted. GSE paper was thus a "laissez-passer&q... for risk.

[bearfund]

Sorry, no. If I had wanted exposure to MBSs, I would have bought MBSs. If I had wanted exposure to house prices, I would have bought a house. Instead I saw that these assets were radically overpriced and bought gold instead. Now you're telling me that I should pay higher taxes to bail out those who, with access to all the same data I had (probably much more, quite frankly), made the wrong decisions I avoided. I have only one response: ---- ---.

[Capt Bob]

I'm going to cheat: Moved my comment-- already made--same subject, different location--please excuse.

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??

[fireball]

JOHNAF agreement. i also blame the borrowers. they are not 3 year olds. if you must borrow to buy you should admit to yourself that you cannot afford the item and proceed with great caution. there is a popular neighborhood about 25miles from my home. it was considered the place to be for the societal elites. when i was looking for the home i now own (just before the credit bubble started deflating) i looked in that area with a realtor friend. i saw home after home that was at least double the price i would have paid. (i kept looking and found this place. it was from a distressed seller.it is extremely private sitting on a lake. even now my friend tells me i could easily sell for a $100,000 profit and if i was patient with the right buyer $200,000) people wanted this neighborhood as a status symbol. they thought living there made them better higher class people. many could not even furnish all of their rooms. i do not want to rescue them from their own vanities. such foolish lending and borrowing deserve the consequences. (i do practice what i preach. i own my new home.) it is a pity that we cannot just let these banking institutions die the death they deserve to make way for the few that have used prudence to step in to the larger roles. this horrible mess has already cost everyone so much in one way or another. i hate to see stupidity rewarded as much as i hate to see success punished. MOHIDEEN i am one of those tax payers and i disagree. i did not stand to profit, i had no say in the deals that were made and i do not deserve to be dragged into it now. however i concede that we are forced to step in. i would very much like to see accountability where it belongs. many banking officials deserve investigation and indictment. forgive me for being amused at the squealing coming out of the aforementioned neighborhood.

[fireball]

CAPTBOB as usual you are right on target with a sense of humor to boot.

[fireball]

does anyone have opinions on regions financial. at one time i held 8,675 shares. luckily for me (it was blind luck) i got rid of 7175 before the trouble. i have the dividend reinvesting because shares are now so cheap. there are many conflicting reports on regions. one says they are in the top twenty list to emerge a big winner from this. another says get out get out get out. a branch president that is an old friend tells me that because of the amsouth purchase they had better reserves than most because they only used half of the funds set aside to complete the absorbtion. at this point it appears best to sit tight and ride it out. anyone think i am being stupid?

[evilll]

To the first comment by Mohideen Ibramsha:
It's a ridiculous proposition. Did anybody be forced by a gun pointing to his head to buy a house in 2005? You buy a house, you assume the risk. Just like you cannot expect government/tax payers to bail out those who bought Lucent or Amazon in 2000 at sky high prices.

[Did U ThinkThe PonziSchemeWould Last?]

I love the way everyone asks "how do we get out". How did they get out of their excesses in 1929? YOU DON'T "get out". You EAT it. It will go on the back of the taxpayer. It will eat away at the value of the USD and thus it will make everyone in the world who hold USD a taxpayer of the USA. It will likely send everyone running and screaming for the door with respect to the USD. It will dethrone the USD as the reserve currency of the world and a basket of currencies will replace the petro dollar.

We will not "get out" of it this time my friend. This time, the USA will be exposed for what it has been for decades: BROKE and POOR.

[fireball]

DID U THINK sad for all who have behaved responsibly. true for all. this sucks.

[Did U ThinkThe PonziSchemeWould Last?]

Fireball, yes, it does suck but the real question is what are we Americans going to do about it? Let the politicians and the federal reserve who caused it all have more power? F--- NO! Doing that makes us even more the victim.

Every American must now learn the true meaning of the word "patriot". A patriot steps up and does his part to make the country right. A patriot does this even if he thinks the gov't will put him on watch lists, etc. Write your congress people at least once a month expressing outrage at the federal reserve and our debt and our fiat currency. Demand that they move back toward the constitution and away from the fascist direction they are now headed. Tell the American people the truth, throw the bums out, and make it so that congessional service is SERVICE again, not a feeding trough for elitist lap dogs.

Every one of us needs to take this once great country back, Martin Luther King stye ("non violence, non violence"). We should not let the few like the Ron Pauls of the world and the Dennis Ks of the world take all the risk.