The historic takeover of the two mortgage giants affects taxpayers and investors. But will it stabilize the housing market?
With the nation riveted on what the next President will do, the current Administration showed on Sept. 7 that it's not ready to take its hands off the economy's steering wheel quite yet. The Bush Administration announced that it had seized control of Fannie Mae (FNM) and Freddie Mac (FRE), two huge but dysfunctional companies whose financial difficulties were weighing down the U.S. housing market and threatening global financial upheaval.
It was a dramatic move for the Republican Administration. The two privately owned companies are in effect being nationalized, something that's ordinarily anathema to conservatives. Treasury Secretary Henry Paulson, who announced the action (BusinessWeek, 9/7/08) at a rare Sunday news conference, justified it by saying that Fannie and Freddie are so "large and interwoven" into the global financial system that "a failure of either would cause turmoil around the world."
The Bush Administration's hand was forced by a dramatic deterioration of the housing market, which eroded the balance sheets of Fannie and Freddie and frightened the global investors who support them. Together, Fannie and Freddie have about $5 trillion in outstanding debt and mortgage-backed securities. Home prices are in a swoon, falling 15% over the past year in 20 major metro areas. Zillow.com, a real estate Web site, estimates that 29% of the homeowners who bought in the past five years owe more on their homes than the properties are worth. On Sept. 5, the Mortgage Bankers Assn. announced that the share of homes entering foreclosure in the second quarter reached 1.19%, the highest in the 29-year history of its survey.
Mudd and Syron Leaving
Allowing either Fannie or Freddie to fail (BusinessWeek.com, 8/28/08), Paulson said, would hurt families' savings, their ability to get home and auto loans, and even hamper economic growth and job creation.
The government will boot out the CEOs of both Fannie and Freddie—Daniel Mudd and Richard Syron, respectively—though they will stay on in advisory roles during a transition. It will ban the companies from lobbying. Treasury will invest up to a maximum of $100 billion in each of the companies in the form of senior preferred shares, as needed, to make sure the companies retain a positive net worth and thus retain the confidence of investors. Treasury will also make secured loans to the two companies if needed, and plans to break precedent and buy some mortgage-backed securities itself to provide financing to housing.
Fannie and Freddie support the housing market by purchasing mortgage loans from the banks that originate them, giving the banks the cash to make more loans. They package those loans into securities and ensure repayment. They sell the securities to investors around the world (BusinessWeek.com, 8/28/07) or retain them for their own portfolios.
Part of the Problem
At one point earlier this year, as the credit crunch worsened, the two companies were responsible for about 80% of all loans being originated in the U.S. But the rise of foreclosures weakened their balance sheets and raised their borrowing costs, reducing their ability to support the market. As the housing downturn worsened, the two companies came to be seen as part of the problem instead of part of the solution.
Technically, Fannie and Freddie have been placed under "conservatorship," a term that ordinarily means they are being stabilized with the objective of returning them to normal operation. In fact, that's how conservatorship was described by James Lockhart, director of their regulator, the Federal Housing Finance Agency, who joined Paulson at the Sunday press conference.
Under the government's conservatorship, Fannie will be run by Herb Allison, a former CEO of Merrill Lynch (MER) who most recently ran TIAA-CREF , the big teachers' pension and retirement fund. Freddie will be run by David Moffett, former vice-chairman of US Bancorp (USB).
Not Business as Usual
In reality, it is almost inconceivable that Fannie and Freddie will get back to business as usual. Paulson made it clear he thinks the companies were structured incorrectly from the start and had an inherent conflict of interest between their duties to shareholders and their obligations to support homeownership. Because of Fannie and Freddie's public obligations as well as their enormous size, investors in the U.S. and around the world correctly surmised that the federal government would never let them fail. In the future, Paulson said, "government support needs to be either explicit or nonexistent."
Paulson also set a deadline for reform, which comes after the Bush team is out of office. He said that under the timeline he envisions, Fannie and Freddie will expand their operations to support the hobbled housing market by buying or insuring more and more mortgages between now and the end of 2009. Starting in 2010, though, Paulson said the two companies should begin shrinking their portfolios at a rate of 10% a year.
December 2009 is also the planned expiration date for a new secured lending facility that's available to Fannie, Freddie, and the 12 federal home loan banks. (Secured loans are ones in which the borrower must post collateral, such as mortgage-backed securities.)
Taxpayers at Risk
It's impossible to say how much the effective takeover of Fannie and Freddie will cost taxpayers. If housing prices begin to recover and foreclosure rates don't get too high, the cost to the government could be very small or zero, because Treasury will earn a return on its preferred shares and get all its secured loans repaid.
Still, the deal is likely to draw criticism because it puts taxpayers at risk while boosting the value of Fannie and Freddie's bonds and mortgage-backed securities, which are held by banks and other investors around the world. Asian central banks, in particular, are large holders.
One group that won't be getting any kind of a bailout: Fannie and Freddie's ordinary common shareholders. They stand last in line for any money the two companies make. Share prices of both Fannie and Freddie have lost more than 90% of their value over the past year, in anticipation of a takeover. In after-market trading on Sept. 5, as word of the conservatorship plans leaked out, Fannie shares were trading around $5.50, down from $70 a year ago, while Freddie Shares were at about $4, down from $65 a year ago.
Candidates Weigh In
Senator Barack Obama, the Democratic Presidential candidate, released a statement on Sept. 7 saying, "Given the substantial role that Fannie Mae and Freddie Mac play in our housing system, I believe that some form of intervention is necessary to prevent a larger and deeper crisis throughout our entire economy." He said he wasn't yet ready to say whether Treasury's solution was the right one.
The Associated Press reported that Senator John McCain, the Republican nominee, said at a rally in Albuquerque: "We need to keep people in their homes, but we can't allow this to turn into a bailout of Wall Street speculators." Doug Holtz-Eakin, McCain's top economic adviser, said that longer term, "We believe these institutions should not be making money" through government support. "They have to shrink to a point where they are not a threat, that they are not operating essentially as a big hedge fund."