The Facts on Fannie and Freddie

Includes: FMCC, FNMA
by: Max Fraad Wolff

A conservator will take full managerial/ownership control and 79.9% of common shares under a contractual agreement. The intent is to wind this arrangement down toward the end of 2010- presumably as stability returns to residential real estate and financial markets. The portfolios will not grow across this period or will shrink to their approximately $850 billion June 30, 2008, levels by the end of 2009. Thereafter, Fannie (FNM) and Freddie (FRE) [GSE] portfolios will shrink toward $250 billion in 10% increments. The Treasury Department will receive senior notes yielding 10% with 12% penalty rates and will replenish capital as needed. Further authority will not be required unless or until these commitments sum to more than $200 billion total.

In addition, the US Treasury will begin buying mortgage backed securities [MBS] from Fannie and Freddie. There are no limits to this process. Thus, the guarantee business will continue, portfolio holdings will be moved onto Treasury books and the firms will be moved away from their ballooning and painful function as mortgage portfolio holders. The stated triple aim of buoying asset markets, home mortgage provision/affordability and protecting taxpayers clearly run at cross purposes. If they did not, past assurance would have worked and this take-over would not be needed.

Long Form:

On Sunday, September 7, 2008, the US Treasury acted on behalf of the US Government to take control of the two largest financial intermediaries in the mortgage market. We knew that action was impending just as we knew that months of assurances from the architects of this plan were disingenuous at best. We are looking to the folks who made many of the problems, smoke screened us and seized assets to right the course of the global mortgage market. Action was necessary, it will likely prove insufficient.

Let's look at where we are now and what has been done. We will start with exploring the actual decisions. Fannie Mae and Freddie Mac entered conservatorship under the Federal Housing Finance Authority [FHFA] effective 08 September 2008.

From the US Treasury/OFHEO/FHFA Fact Sheet of 07 September 2008:

The Conservator controls and directs the operations of the Company. The Conservator may (1) take over the assets of and operate the Company with all the powers of the shareholders, the directors, and the officers of the Company and conduct all business of the Company; (2) collect all obligations and money due to the Company; (3) perform all functions of the Company which are consistent with the Conservator's appointment; (4) preserve and conserve the assets and property of the Company; and (5) contract for assistance in fulfilling any function, activity, action or duty of the Conservator.

This does not preclude receivership of Fannie and Freddie, it transfers obligations and operations to the FHFA conservator.

The Conservator cannot make a determination to liquidate the Company, although, short of that, the Conservator has the authority to run the company in whatever way will best achieve the Conservator's goals (discussed above). However, assuming a statutory ground exists and the Director of FHFA determines that the financial condition of the company requires it, the Director does have the discretion to place any regulated entity, including the Company, into receivership. Receivership is a statutory process for the liquidation of a regulated entity. There are no plans to liquidate the Company .

We all knew a day would come when the debt overhang from the housing bubble created major tax payer losses of a direct variety. September 7th was that day. We all knew our growing foreign debt and fears regarding holding dollar assets - especially mortgage related assets - would create a scenario where US taxpayers were forced to make foreign debt holders whole. September 7th was that day.

Leading up to September 07, 2008, major foreign central bank holders of GSE debt began to reduce their holdings. Investors lost interest and demanded higher premiums. The nearly $1.4 trillion in foreign holdings of Fannie and Freddie backed debt were at risk. The Treasury found its hand forced and failed to rally buyers with assurances. The teetering state of the mortgage markets and the $4.6-$4.9 trillion position of Fannie and Freddie placed the GSE at the center of these crises. The extreme weakness - universally denied by OFHEO/Treasury/Government officials - required immediate action just weeks after the latest round of empty assurances.

The actions announced are full of ambiguity, massive scope for unspecified future decision making and multi-hundred billion dollar liability for US taxpayers. They assure nearly the full faith and credit - but not exactly the full faith and credit - of the US government to Fannie and Freddie debt.

The Deal, from the US Treasury Fact Sheet September 07, 2008:

Terms of the Agreements:

  • The agreements are contracts between the Department of the Treasury and each GSE. They are indefinite in duration and have a capacity of $100 billion each, an amount chosen to demonstrate a strong commitment to the GSEs’ creditors and mortgage backed security holders. This number is unrelated to the Treasury’s analysis of the current financial conditions of the GSEs.
  • If the Federal Housing Finance Agency determines that a GSE’s liabilities have exceeded its assets under generally accepted accounting principles, Treasury will contribute cash capital to the GSE in an amount equal to the difference between liabilities and assets. An amount equal to each such contribution will be added to the senior preferred stock held by Treasury, which will be senior to all other preferred stock, common stock or other capital stock to be issued by the GSE. These agreements will protect the senior and subordinated debt and the mortgage backed securities of the GSEs. The GSE’s common stock and existing preferred shareholders will bear any losses ahead of the government.
  • In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation:
    • $1 billion of senior preferred stock in each GSE
    • Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price
  • The senior preferred stock shall accrue dividends at 10% per year. The rate shall increase to 12% if, in any quarter, the dividends are not paid in cash, until all accrued dividends have been paid in cash.
  • The senior preferred stock shall not be entitled to voting rights. In a conservatorship, voting rights of all stockholders are vested in the Conservator.
  • Beginning March 31, 2010, the GSEs shall pay the Treasury on a quarterly basis a periodic commitment fee that will compensate the Treasury for the explicit support provided by the agreement. The Secretary of the Treasury and the Conservator shall determine the periodic commitment fee in consultation with the Chairman of the Federal Reserve. This fee may be paid in cash or may be added to the senior preferred stock.
  • The following covenants apply to the GSEs as part of the agreements.
    • Without the prior consent of the Treasury, the GSEs shall not:
      • Make any payment to purchase or redeem its capital stock, or pay any dividends, including preferred dividends (other than dividends on the senior preferred stock)
      • Issue capital stock of any kind
      • Enter into any new or adjust any existing compensation agreements with “named executive officers” without consulting with Treasury
      • Terminate conservatorship other than in connection with receivership
      • Sell, convey or transfer any of its assets outside the ordinary course of business except as necessary to meet their obligation under the agreements to reduce their portfolio of retained mortgages and mortgage backed securities
      • Increase its debt to more than 110% of its debt as of June 30, 2008
      • Acquire or consolidate with, or merge into, another entity.
  • Each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion.

The assurances in this agreement are cut from the same clothe that was pulled over the public eyes regarding the health and function of Fannie and Freddie for years. That said, these actions reduce the strain on these firms by placing them at the feet of the US government. This will induce greater purchase of and confidence in GSE debt. The additional announcement of US Treasury buying of unspecified and unlimited quantities of mortgage backed securities [MBS] will divert public funds to rescue bond holders and repair the books of institutions, foreign and domestic, that hold Fannie and Freddie issued or backed assets.

As of June 30, 2008, the total portfolios of Fannie and Freddie stood at approximately $1.6 trillion. The Treasury is promising to cap exposure at $1.9T at year end 2009. Thereafter, the conservator has to reduce exposure toward $500 billion in 10% increments. These firms will have to limit the growth in their activities and then begin a massive reduction in debt and risk exposure. The set of commitments to saving taxpayer money runs counter to absorbing mortgage backed securities and supporting housing by buying mortgages.

It is clear that this plan attempts to substitute government backing and guarantee activity for purchase of mortgages and mortgage bundles. It is not clear how this will reduce mortgage finance difficulty. The Treasury is proposing to buy MBS and transform mortgage bundles into Treasury Securities. The taxpayer support provisions clash with facilitating home lending and strengthening balance sheets. At least one, likely two, of these goals may have to be sacrificed. That is the basic truth that led us to this point.

Federal funds and employees will now guarantee mortgages. Fannie and Freddie debt holders will be paid all interest and principle. Safeguarding taxpayers and supplying plentiful and affordable home loans are secondary priorities. Soon the Treasury will begin buying Fannie and Freddie backed MBS from the conservator of the FHFA itself in variant form. There is no explicit stated limit to the size of these purchases and they will be made consistent with the below adjectives. 

From the Treasury GSE MBS Purchase Program Fact Sheet:

  • Congress granted Treasury authority to purchase MBS in the Housing and Economic Recovery Act of 2008. The authority expires on December 31, 2009.
  • Treasury will begin later this month by investing in new GSE MBS, which are credit-guaranteed by the GSEs. Additional purchases will be made as deemed appropriate.
  • Treasury can hold this portfolio of MBS to maturity and, based on mortgage market conditions, Treasury may make adjustments to the portfolio.

The circular and confusing nature of statements and provisions creates massive scope for action and very limited concrete guideline regarding cost, impact and size of balance sheet effects, losses and MBS market intervention.

There is nothing in this provision that makes earnings short and over indebted homeowners more likely, able or inclined to repay loans. There is nothing in this provision that extents support to underwater or at risk homeowners. The first, direct and clearest provision makes whole owners of Fannie and Freddie debt while whipping out common shareholders and transferring hundreds of billions of dollars in liability to the Federal Government. Taxpayer monies will be used - if and when needed - to honor payments to foreign and domestic mortgage backed security investors.

That much we know is true, the rest we hope for and remains to be seen.

Stock position: None.