Fannie, Freddie, and fears of a market meltdown
Concerns about the financial stability of Fannie Mae and Freddie Mac sent have shares of the
two companies plummeting by around 75 percent in the past year, ultimately forcing the federal
government to legislate the ability to step in and support them. Now, investors are wondering if a
bailout by the federal government—a move many industry analysts say would be disastrous for
the world’s financial markets—will be necessary. How did we get here, and where are we going?
The early days of Fannie and Freddie
The Federal National Mortgage Association (FNMA), which is usually referred to as Fannie Mae,
and the Federal Home Mortgage Corporation (FHMC), which is usually referred to as Freddie
Mac, make and guarantee home loans.
Fannie Mae was founded in 1938. In the wake of the Great Depression, the housing market
collapsed, and private lenders were wary of making home loans. Franklin Delano Roosevelt’s
New Deal designed Fannie Mae to save the mortgage market by providing local banks with
money to finance home loans.
In its early days, Fannie Mae operated much like a national savings and loan. Then, in 1968,
President Lyndon B. Johnson privatized the company in order to remove it from the national
budget, a move that was most likely the result of fiscal pressures created by the Vietnam War.
At this point, Fannie Mae began operating as a government-sponsored enterprise (GSE), which is
a private company, owned by shareholders and listed on a stock exchange, but at the same time
financially protected by the federal government.
In 1970, in order to prevent a monopoly from forming, the federal government created another
GSE, Freddie Mac.
Today, Fannie Mae and Freddie Mac buy home loans from lenders, then hold them in their
portfolios or repackage them into bonds that are called mortgage-backed securities.
Fannie Mae and Freddie Mac make money, primarily, by charging a fee on loans they have
repackaged into mortgage-backed securities. Purchasers of the companies’ mortgage-backed
securities pay this fee in exchange for Fannie Mae and Freddie Mac taking on a number of risks.
Perhaps the greatest one is credit risk, which is the possibility that the borrowers of the
underlying loans will default. In essence, Fannie Mae and Freddie Mac guarantee that the
principal and interest on loans underlying their mortgage-bascked securities will be paid—even
if the borrower defaults.
As GSEs, Fannie Mae and Freddie Mac have myriad government protections, perhaps the most
notable of which are access to a line of credit through the U.S. Department of Treasury and
exemption from Securities and Exchange Commission (SEC) oversight.
A problematic history
The companies’ exemption from SEC oversight has, throghout the years, been of great concern
to many investors. To understand why, it is important to realize what a significant role Fannie
Mae and Freddie Mac play in the nation’s—and even the world’s—economy.
Fannie Mae and Freddie Mac are the country’s largest buyers of home loans. Together, they own
or guarantee around $5 trillion of mortgages, which is close to half of the nation’s mortgage
market. Because they promise to step in and make good on their loans if the homeowners default,
the companies are guaranteeing trillions of dollars worth of loans. That makes them major
players in the nation’s housing market.
At the same time, the companies’ status as GSEs—and resulting exemption from SEC
oversight—means they are not required to report any financial difficulties that they may be
having to the public. They are the only two Fortune 500 companies with such a privilege.
Together, those two factors worry many investors, because if one of the companies should
experience difficulty—or worse yet, collapse—it’s possible that no one would know until it was
too late. That could be disastrous for shareholders of the companies, for obvious reasons—but
also for the the entire credit market. Fannie Mae and Freddie Mac, and the mortgage-backed
securities they issue, are not explicity backed by the U.S. government. But any possibility of
their failure would likely lead to a meltdown in the world credit markets, because if their
guarantee is deemed worthless, millions of people worldwide who hold their mortgage-backed
securities would panic, try to sell, and ultimately lose money.
As a result, the investment community generally agrees that the federal government w ill not
allow the collapse of Fannie Mae and Freddie Mac. And if the federal government takes over the
companies, U.S. taxpayers could be on the hook for hundreds of billions of dollars.
While these fears may seem overdone, they are not completely unjustified, as the companies
have been plagued by scandal throughout their history. In 2003, for example, Freddie Mac
revealed that it had understated its earnings by almost $5 billion, and was fined $125 million.
And in 2004, Fannie Mae came under investigation for widespread problems in its accounting
practices, including shifting losses so senior executives could earn generous bonuses.
Recently, worries about Fannie Mae and Freddie Mac have increased due to the state of the
housing market. Before we explain why, let’s look at the history of the subprime crisis.
The subprime crisis
From 1998 though 2005, nationwide housing prices rose at an average annual rate of around 7.25
percent or 10 percent, according to the two most widely cited measures of housing prices, the
Office of Federal Housing Enterprise Oversight (OFHEO) Index and the S&P/Case-Shiller
(S&P/CS) Index, respectively. Even more dramatic numbers were seen during the last two years
of the housing market boom, 2004 and 2005, when the OFHEO Index rose 9 percent per year
and the S&P/CS Index rose more than 13.5 percent per year.
As a result, from 2004 to 2006 everyone wanted to get in on the action, including borrowers who
could not qualify for traditional mortgages. These borrowers existed all over the country, of
course, but the two most notable groups of borrowers were concentrated in the sunbelt states and
the upper Midwest. The sunbelt states—such as Arizona, California, Florida, Nevada and
Texas—had booming real estate markets, and non-traditional mortgages helped borrowers afford
larger homes by offering lower payments. In the upper Midwest states—such as Illinois, Indiana,
Michigan and Ohio—housing prices were not rising significantly, but deteriorating labor market
conditions (such as in the automotive industry) created a number of borrowers who could not
qualify for traditional mortgages.
In response to this demand, lenders made credit available to these borrowers. Instead of getting
traditional mortgages, borrowers took out subprime mortgages, which are made to individuals
with questionable credit histories, and Alt-A mortgages, which are made to individuals who
don’t have documented income. These mortgages also had a number of features that were
designed to keep monthly payments low. For example, the commonly used 2/28 adjustable rate
mortgage (ARM) had an initial interest rate set for two years and a floating interest rate
thereafter. There were also interest-only mortgages, negative-amortization mortgages, and—
something that may seem bizarre as we look back—option mortgages, which allowed the
borrower to decide how much he or she wanted to pay each month.
Lenders and companies such as Fannie Mae and Freddie Mac took these subprime mortgages,
and, as they did with all mortgages, created mortgage-backed securities. Sometimes, those
securities had different “tranches,” each with different streams of income. For example, the first
tranche’s income stream might be relatively secure, the second tranche’s income stream less so,
and third tranche’s income stream even less so. And, losses were allocated from the bottom up.
With this kind of structure, companies that repackaged mortgage-backed securities were able to
obtain investment-grade ratings on billions of dollars of securities that had relative unsecure
credit—that is, subprime mortgages—as underlying collateral.
That created a whole new audience for mortgage-backed securities—namely, investors who had
no expertise evaluating the underlying collateral of mortgage-backed securities, and instead went
solely by the rating.
In a vicious circle, that created even more demand for subprime mortgages. Subprime mortgage
originations grew from $35 billion in 1994 to $140 billion in 2000, an average annual growth
rate of 26 percent, according to the Federal Reserve Bank. Similarly, subprime originations as a
share of total mortgage originations grew from 5 percent in 1994 to 13.4 percent in 2000.
As noted above, this continued through 2005. Then, in 2006, everything fell apart as two
economic situations combined to create what many industry insiders say was the perfect storm:
Interest rates began to rise, and housing prices began to weaken.
First let’s look at interest rates. As noted above, a 2/28 ARM is originated with a low initial
interest rate. After two years, the interest rates reset to a level based on the then-current six-
month LIBOR rate plus a margin. It resets at least annually thereafter. As an example of how this
impacted the subprime borrower, take the typical interest rate on a 2/28 ARM in early 2005,
which was around 5 percent. At the time, ARMs taken out by subprime borrowers typically reset
to LIBOR plus around 6 percent. With LIBOR around 5 percent, it meant loans charging 5
percent interest quickly jumped to 11 percent. A homeowner with a $200,000 mortgage would
see his or her payment jump from around $1,200 to more than $2,000.
Now, we all know what borrowers who cannot make their mortgage payment do: They refinance
or sell their home. This time, though, they could not refinance because interest rates were rising,
and they could not sell because the housing market was plummeting. In 2007, sales of existing
single-family homes fell by 13 percent, the largest amount in 25 years, according to the National
Association of Realtors. At the same time, the median home price dropped 1.8 percent to
$217,000 for the entire year—the first annual price decline on record, which goes back to 1968.
Lawrence Yuan, the chief economist at the National Association of Realtors, called the decline
unlike any seem since the Great Depression.
Borrowers who could not make their mortgage payments had only one choice, and delinquencies
and foreclosures on subprime loans started to rise. In the first quarter of 2006, the seasonally
adjusted delinquency rate for subprime loans was 11.50 percent, according to the Mortgage
Bankers Association. In the first quarter of 2008, that number had risen to 18.79 percent. At that
time, subprime ARMs represented 6 percent of U.S. loans outstanding and 39 percent of U.S.
foreclosures started.
Where are we now?
When the subprime meltdown first began, many economists thought it would be contained to
2007. But the crisis continues to unfold.
First, it does not appear that lenders—despite their claims to the contrary—rediscovered credit
quality after the subprime woes first surfaced. Subprime loans that originated in 2007 are
defaulting at even faster rates than those originated in 2005 and 2006, according to Moody’s.
Seven percent of 2007 subprime loans were defaulting within the first three months of
origination, compared to just 4 percent of 2006 subprime loans.
Moreover, we are at the point at which many ARMs reset. It has been estimated the value of
subprime loans resetting to a higher interest rate will be $500 billion in 2008, up from $400
billion in 2007. If that is indeed true, we will likely continue to see high default and foreclosure
rates through 2008 and into 2009.
Supporting that, foreclosure filings grew by 53 percent year-over-year in June, according to
RealtyTrac, which monitors default notices, auction sale notices and bank repossessions.
Nationwide, 252,363 homes received at least one foreclosure-related notice in June—one in
every 501 U.S. households. And, more than 71,000 properties were repossessed by lenders. The
problem was nationwide, with foreclosure filings increasing year-over-year in all but 11 states.
Nevada, California, Arizona, Florida and Michigan continued to have the highest foreclosure
rates. In fact, in Nevada, one in every 122 households received a foreclosure-related notice in
June, more than four times the national rate.
What does it mean for our old friends Fannie and Freddie?
As the credit markets have dried up, Fannie Mae and Freddie Mac have played an essential role
in the country’s mortgage market. Essentially, they have been the lenders of last resort, providing
much-needed liquidity to the housing markets. As a result, banks and other lenders have been
able to make loans they otherwise wouldn’t have been able to make, and make them at lower
rates.
But, now that homeowners are defaulting and being foreclosed on at alarming rates, Fannie Mae
and Freddie Mac are being forced to make good on their guarantees. Since last July, they’ve
reportedly posted combined losses of close to $13 billion, and investors are worried there are
more losses to come.
Worries about companies’ subprime exposure have led their stock to decline for months, but the
panic hit a crescendo in mid-July when a report from a Lehman Brothers analyst warned that a
proposed accounting rule change would require the two companies to keep significantly more
capital on hand. The Financial Accounting Standards Board is reviewing a rule that might force
financial firms to take mortgage-backed securities that are currently off their balance sheets and
place them on their balance sheets. If Fannie Mae and Freddie Mac have to do so, Fannie Mae
would have to add $46 billion to its reserves, the report said, and Freddie Mac would have to $29
billion. In today’s tight credit market, that kind of cash could be hard to raise. Indeed, Mark
Zandi, chief economist for Moody’s Economy.com, has said that the companies may need to
issue more stock to raise money, which would dilute the value of existing shares.
Adding insult to injury, not long after the Lehman Brothers report came out, a former Federal
Reserve governor said he believes Fannie Mae and Freddie Mac are already insolvent, and urged
the federal government to take them over. Granted, that governor has long been critical of Fannie
Mae and Freddie Mac, but it was a serious statement, because if the government takes over the
companies, shareholders would likely get nothing—and U.S. taxpayers would be on the hook for
all the companies’ debt.
The selloff began. Immediately after the markets opened on July 11, shares of Fannie Mae and
Freddie Mac fell more than 47 percent from their already battered closing price the day before.
Although they made up much of their losses, with Fannie Mae finishing the day down 22 percent
and Freddie Mac finishing the day down 3 percent, both companies’ stock ended down around
45 percent for the week and 75 percent for the year.
As evidence of the companies’ importance to the U.S. economy as a whole, the problems at
Fannie Mae and Freddie Mac also weighed on the broader markets, at one point forcing the Dow
Jones Industrial Average down past the 11,000 mark for the first time in nearly two years.
How fundamental are the problems?
Suddenly, Fannie Mae and Freddie Mac were the topic of the day. Media pundits debated if the
companies were really in trouble, or if the selloff was just the result of a temporary panic. It
seemed like everyone had an opinion.
As noted above, many thought the companies were insolvent. Others, however, said the
companies were doing just fine. For example, the Office of Federal Housing Enterprise
Oversight (OFHEO), the primary federal regulator for Fannie Mae and Freddie Mac, said the two
companies were “adequately capitalized,” meaning they have enough cash on hand to stay in
business. And in a July research note, a Keefe, Bruyette & Woods analyst wrote that the OFHEO
already requires reserves for off-balance sheet securitizations, and because of those requirements,
in part, the pair would not be affected by new accounting standards. Even Senator Christopher
Dodd, the chairman of the Senate Banking Committee, has defended the strength of the two
companies.
But the bigger question on investors’ minds is: If the companies are indeed in trouble, will the
federal government take advantage of the legislation it authorized, step in and save them?
The “bailout”
As noted above, the law that created Fannie Mae and Freddie Mac explicitly says the
government does not guarantee the loans. But, there is a widespread belief that Fannie Mae and
Freddie Mac are backed by some sort of implied federal guarantee.Vernon L. Smith, 2002 Nobel
Laureate in economics, has even created a new name for such an arrangement, calling Fannie
Mae and Freddie Mac “implicitly taxpayer-backed agencies.”
As a result, a majority of investors believe that Fannie Mae and Freddie Mac are simply too
important to the economy for the federal government to let them fail, and policymakers would
step in to prevent a default.
Policymakers have echoed that belief. On July 13, the Federal Reserve said it is giving Fannie
Mae and Freddie Mac the same access to Federal Reserve Bank of New York funds as
commercial banks and Wall Street firms. And, Treasury Secretary Henry Paulson proposed a
plan to extend credit to Fannie Mae and Freddie Mac or purchase equity in the companies, if
necessary.
“They play an important and vital role in our economy and housing markets today, and they need
to continue to play an important role in the future,” Paulson told legislators.
Congress ultimately authorized the plan, which allows the Treasury Department to provide an
unlimited line of credit to Fannie Me and Freddie Mac, and take an equity stake in either
company, over the next 18 months.
Although Paulson called the plan a “backup facility [that] hopefully would never be used,” one
analyst noted that “blank checks almost always get filled in and cashed.”
So, despite much recent talk about the government’s “bailout” of Fannie Mae and Freddie Mac,
all the recent legislation did, as noted above, is authorize intervention by the Treasury
Department if it becomes necessary. So far, the government has spent only $94,000 on the so-
called bailout—paid to Morgan Stanley to provide “market analysis and financial expertise” in
connection with its rescue plan.
How likely is government intervention?
Sharp losses at Fannie Mae and Freddie Mac continued in August, with both companies posting
larger-than expected second-quarter losses—$2.3 billion for Fannie Mae and $821 million for
Freddie Mac.
The companies continue to insist they can make it through these troubled times. Freddie Mac, for
example, said it can handle $40 billion in credit losses through next year if it obtains $5.5 billion
in additional equity, but it is waiting for market conditions to improve to raise that money
But, many analysts say $5.5 billion when market conditions improve will be too little too late—
and either investors will be massively diluted, or the company will be nationalized.
Indeed, the 53 economists polled in a recent Wall Street Journal survey said there is a 59%
probability that the Treasury Department will have to step in.
Should the government intervene?
When asked how the government should handle the situation with Fannie Mae and Freddie Mac,
68% of those surveyed by the Wall Street Journal said the companies should raise capital
privately.
The core belief behind that position is that it is the companies’ own poor mortgage lending
practices that helped put the country in the subprime crisis—and if they falter as a result, the
government should let them fail. After all, to many, there is no crisis that cannot be made worse
by government intervention. By stepping to save Fannie Mae and Freddie Mac, it can be argued,
the government will be creating an even bigger financial pickle.
But for every position there is an opposing position. Former Fed Chairman Alan Greenspan
recently criticized Fannie Mae and Freddie Mac as fundamentally flawed institutions that
privatize profits and socialize losses. “They should have wiped out the shareholders, nationalized
the institutions with legislation that they are to be reconstituted—with necessary taxpayer
support to make them financially viable—as five or 10 individual privately held units, and
auctioned off,” he said.