Saturday, July 12, 2008

Fannie, Freddie, Ginnie …What's going on in the mortgage industry?

I don’t know. Wall Street is once again pronouncing the end of the world. Shares of Fannie Mae and Freddie Mac have plunged 75% or more over the year. The U.S. banking system is now on the verge of failure….or so we are being told.

Certainly, this is not the first time that the banking sector has been under duress. The Saving & Loan Crisis of 1980 cost the Federal Savings and Loan Insurance Company (FDIC) $175 billion. The hope bandits in the media are rattling on about a revision to an accounting rule that could require Fannie and Freddie to add $5 trillion to their balance sheets. A move that would cripple Fannie Mae and Freddie Mac, who are the epicenter of the secondary U.S. mortgage markets.

In this article, I cover the last week’s events regarding Fannie Mae’s and Freddie Mac’s troubles. My conclusion is that the recent financial duress is based mostly on speculation, and that in reality, the macroeconomic consequences are limited. The government will guarantee the financial health of Fannie and Freddie, and at a lower cost than the $5.3 price tag that is blabbed about in the media. Further, the proposed change to accounting standards that started it all will not occur. The banking system will survive.

A little background

Who are Fannie Mae and Freddie Mac? Fannie Mae was created by the federal government in 1938 to insure that mortgage loans were available on a continuous basis. Until 1970 and under the direct control of the government, Fannie Mae guaranteed mortgage loans and purchased, held, or sold them on the secondary market. A local bank would loan money to a homeowner, and Fannie would buy the rights and risk of that loan, and in turn free up cash for the local bank to make more loans. In 1964, the federal government removed its explicit backing of Fannie Mae, and attached several benefits to the Fannie Mae in return for guaranteeing the mortgages it bought. In 1968, Fannie Mae split into Ginnie Mae with continued control by the government, and a new publicly owned Fannie Mae. Stock shares of Fannie Mae were issued, and Mortgage-Backed Securities (MBS) were created. Over the next 20 years, several regulation shifts, including the creation of Freddie Mac, led to the Office of Federal Housing Enterprise Oversight (OFHEO), which oversees the proper capitalization of Fannie and Freddie (make sure that they have enough of the right types of assets to insure a healthy institution – one free of large default risk). Fannie Mae and Freddie Mac enjoy benefits, like special capitalization requirements and tax incentives, not seen by other institutions.

Fannie Mae and Freddie Mac buy and sell mortgages by wrapping them up into assets called MBSs. This is the locomotive that keeps the loanable funds flowing to homebuyers like you and I. According to the New York Times, Fannie and Freddie jointly guarantee roughly $5.3 trillion (half) of all U.S. mortgages. How big is $6 trillion? It is 43% of $14 trillion, or U.S. total income….alot.

Here rests the worst-case scenario: Fannie and Freddie go under (default) and the mortgage market ceases to operate under a guarantee. There will be no secondary mortgage market, and many homebuyers will not be able to secure a mortgage (the risk to banks has become infinitely larger). Many potential homebuyers cannot secure loans, the demand for housing falls sharply, and the price of housing is further depressed. Home prices will be forever lower.

All of you out there with a mortgage, your net-worth will fall substantially. Many will default on their mortgage, and bank losses will mount quickly. A large-scale credit disaster will result and the the entire U.S. credit system will stop in its tracks (both nationally and internationally). Getting scared? I assure you that Wall Street is.

Back to the issue at hand

What happened over the last week to bring into question the health of the banking system (again)?

First, Lehman sent out its report

The FASB’s proposed revision to public accounting standards would require that assets normally considered off balance sheet would be added to bank balance sheets. Fannie Mae’s and Freddie Mac’s loan guarantees ($5.3 trillion), which are currently booked off of their balance sheets, would be counted as liabilities on their balance sheets. Fannie and Freddie would need to raise enough capital to offset the liability of $5.3 trillion in mortgage guarantees. An analyst at Lehman Brothers, Bruce Harting, speculates that the price tag would be $75 billion.

In an environment where banks are tight for cash, it is unlikely that Fannie Mae and Freddie Mac could raise that much capital. Banks are taking hits left and right. Citigroup, Merrill Lynch, UBS, Wachovia have all recorded losses (or soon will), and the IMF estimates that total mortgage-related losses could reach $1 trillion. Nobody wants to give money (via stock or bonds) to banks right now.

Second, the former Fed President, William Poole, stated the following:

Congress ought to recognize that these firms [Fannie Mae and Freddie Mac] are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer.

Essentially he vocalized that Fannie Mae and Freddie Mac are at risk of default, and that a government bailout is, but shouldn’t be, on the horizon. Already skiddish stockholders sold off shares of Fannie and Freddie at an alarming rate, confirming that the two firms could not raise the capital required to cover new standards.

If Fannie and Freddie can’t survive, how can the rest of the economy? A bit on the extreme side, don’t you think?

The economics of the Fannie and Freddie situation

In short, Harting and Poole created a whirlwind of speculation on the failure of two institutional giants. Although Fannie and Freddie are not explicitly backed by the U.S. government, it is widely believed that the government will step in if either Fannie or Freddie were in danger of failure. I agree with Poole, they shouldn’t be given special privileges, but they are, and those privileges will continue long past the credit crisis (or so called) is over.

What is the government to do? How will the fallout affect the U.S. economy?

First, the new standards requiring firms to raise new capital on off-balance liabilities will most certainly exclude Fannie and Freddie, or they will not be put in place at all. Sure, talk is tough, but when it comes down to it, the government will not let the mortgage giants go under. There is simply too much at risk…a.k.a, the whole housing market.

Second, if Fannie and Freddie are indeed insolvent (liabilities greater than assets), then the second option is for the U.S. government to nationalize the two firms: it’ll just be Ginnie Mae with no Fannie or Freddie. Share holders will suffer, but why shouldn’t they? The stock market is inherently risky. When you buy a stock, you buy an asset that is not “safe.” Banks should be allowed to fail.

Third, and assuming that all U.S. homeowners default on loans guaranteed by Fannie and Freddie, the U.S. government would add $6 trillion worth of loan guarantees to its current debt tab of $9.5 trillion. Such an increase in government debt would certainly reduce the U.S. government’s international debt ratings. But why couldn’t they simply sell the assets to some private entity? I am sure that Saudi Arabia or China would love a piece of the U.S. housing market. And if you think about it, it is highly improbably that the U.S. would acquire $5.3 trillion since most homeowners do not default on their mortgages. Currently, less than 6% of all mortgages are more than 60 days past due. Worst case is all of those 6% default, so 6% of the $5.3 trillion ($300 billion).

Which brings me back to my first point: Fannie and Freddie will be exempt from any new accounting standard over at the FASB, or if they cannot be exempt, the new standard will not go into effect.

I believe that this will blow over – what do you all think? I would certainly love to start a conversation here. Please leave comments. Best, Nontruths


  1. Well done for this wonderful blog.

  2. Thanks, again, for some rational thinking. This can lead us all back to people's lack of a basic savings plan - 5/6 months of living expenses in cash or the equivalent. We also need to rethink whether or not everyone is "entitled" to what we refer to as the "American dream" of home ownership. I can remember my parents talking about saving all of the cash to buy their first home in the depression era. It required a LOT of sacrifice on their parts. Maybe that is the word I've been trying to find - "Sacrifice". Are any of us willing to do that to achieve a goal? Rambling on again, janie