Funding the Fannie/Freddie Bailout: Why Taxpayers Will Get Stuck With the Tab

Housing finance giants Fannie Mae (FNM) and Freddie Mac (FRE) have been on the verge of collapse for many months now, but unlike Bear Sterns, Tyco, and Enron, Fannie and Freddie are just too big to let fail.

The bankruptcy of either of these government-sponsored entities (GSEs) would have immediate and devastating consequences to this country’s entire mortgage system and the broader economy. The recently passed Housing Bill is a good first step, but investors need more than a mere confidence boost. We need real housing reform and solutions that address both credit and lending.

The quick and painful drop in the U.S. housing market has left lenders of all shapes and sizes holding the bag on depreciating asset portfolios—except for Fannie and Freddie. These two public/private hybrids have implicit, and now explicit, guarantees from the United States government (i.e., taxpayers like you and me) for protection against huge losses that would otherwise bankrupt these historic institutions. However, this system of independent companies backed by government commitments does not equitably serve homeowners, lenders, or the government.

As housing lenders and mortgage buyers watched the value of their holdings fall significantly, credit tightened forcing up companies’ financial leverage, posing major problems for Fannie and Freddie. According to their respective balance sheets as of March 31, 2008, Fannie Mae currently has a debt-to-equity ratio of 20.71, and Freddie Mac has a debt-to-equity ratio of 49.11. These ratios have increased significantly over the past year with Freddie Mac nearly doubling its financial leverage year over year.

Thus, highly levered, with foreclosure rates surging, Fannie’s and Freddie’s cash flows shrank as losses continued to mount. As quasi-public institutions that control such a large percentage of the nation’s mortgages, it is irresponsible to have such high debt-to-equity ratios; but, with a government crutch to lean on, Fannie and Freddie could push their ratios up without the worry that most other public companies would endure.  

Helping to bring about the precipitous decline of Fannie and Freddie was an increasing number of bad loan originators, some of them not properly licensed and offering riskier mortgages to hopeful loan owners. These mortgages produced substantial profits, which attracted larger housing lenders looking to improve their margins. Lenders bought mortgages from these smaller loan originators in addition to approving their own sub-prime loans. Then GSEs, recognizing that they were losing market share and profits to such housing lenders, started to buy some of the riskier mortgages from the housing lenders.

Fannie and Freddie abstained from buying the extremely risky mortgages, albeit they pushed the limits about as far as legally allowed. They bought mortgage-backed securities that had a share of solid, trustworthy mortgages but which also included riskier mortgages in the package. However, with the implicit “safety net” provided by the United States government, these two financiers were practically implored to take on high-risk, high-reward mortgages.

With this knowledge one wonders how any management team could run properly a company if they know they will get bailed out if things turn sour. This is the essence of why being a quasi-public company is a problem:  Management is working to gain market share and profits while disregarding inherent associated risks, principally because they have a federal guarantee.  

Should Fannie and Freddie be privatized? 

No. The recent sub-prime mortgage debacle has revealed fraud and other problems in our private mortgage system that must be addressed before we can trust the $5 trillion that Fannie and Freddie hold or guarantee in mortgages to the free market. The sub-prime mortgage crises was fed by the greed (and sometimes the fear) of management teams to maximize shareholder profits without sufficient consideration given to the substantial inherent risks of their actions. As we have learned over the past year, many private companies are driven to make money in the short-term without much forward thinking as to the long-term consequences.  

Should government control Fannie and Freddie?

No. President George W. Bush has stated his goal to create an ownership society, but nationalizing Fannie and Freddie does not achieve this goal any more than socialized medicine provides world-class health care. Governments should not perform the role of the free market or provide safety nets to private corporations.

What should we do? 

There were numerous warnings signs of a potential Fannie/Freddie collapse, but they were all but ignored along side the rest of the recent crisis in the financial sector. Fannie and Freddie over leveraged their assets, relied on government guarantees to remain solvent, and have lost 90% of their share price in the process. Now Congress and the Bush administration want to provide cheaper loans and/or infusions of equity to resuscitate these limp institutions. Cheaper loans and government infusions of equity (again funded by our tax dollars) are not the solution to our inherently flawed and conflicted mortgage system. Tighter regulation, transparency, and oversight of mortgage lenders and lending practices, including the proper licensing and examining of loan originators, is needed to shore up the mortgage crisis.

Fannie and Freddie are indeed too big to fail, and though in failure we often discover the seeds of success, as long as the resuscitation of these mortgage monoliths is institutionalized, as we know them today, these great financial institutions will never stand and succeed on their own.

Comments

[Chris in AZ:]

I never thought about it this way. I guess when the housing prices began to decline they were forced by our capitalist economy to either take risky loans or lose business or profit share. I wonder though, does this mean the government would bail out Wal-Mart, if they begin to fail since they are so integral to our economy? At which point will our “hands off” government remain hands off in the financial sector? Too, why is the socialized government model so despised, if some companies and some people need it at times? Can’t we as Americans just pull our heads out of our asses and take an objective look at how corrupt our government can became, and realize; regulation doesn’t necessarily mean lower productivity.

2008 Aug 07 11:08 AM

[jimmy46:]

The sub-prime mortgage crises was fed by the greed (and sometimes the fear) of management teams to maximize shareholder profits""""

NOT TRUE, IT WAS DONE TO INCREASE BONUSES FOR THE PLAYERS AT THE WALL STREET iBanks.

2008 Aug 07 05:12 PM

[Kunst:]

"I guess when the housing prices began to decline they were forced by our capitalist economy to either take risky loans or lose business or profit share."

Some think government regulation is a bad thing. Actually, it is just setting (and enforcing) the rules of the game so that everyone has a level playing field and the system is rational. Without this function, all business would be a race to the bottom. Whoever can cut costs by exploiting workers, cheating customers, ignoring risks, trashing the environment, and neglecting safety would "win". By the time we realize what a mess has been created, the responsible players have been driven out of business.

2008 Aug 09 10:02 PM