The government takeover of Fannie and Freddie Mae

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The Frannie and Freddie Mae Bailout: A History and Overview

The Housing Crisis has claimed its two largest victims: Freddie Mac and Fannie Mae. Plans have been announced to place these institutions into conservatorship (I'll get to that in a minute). What follows is

1.) A brief explanation of what Fannie and Freddie do and why they are so important

2.) Why they are in trouble, and

3.) And overview of the government's plan.

This will be a long article, so get ready to sit awhile.

A Brief Explanation of Fannie and Freddie
So, what do these two institutions do? Why are they so important?
Let me explain that by comparing the mortgage business of 100 years ago to the mortgage business of today. 100 years ago, a borrower would go to a bank and get a home loan. However, the bank would own the loan for the duration of the loan - that is, the bank that made the original loan would be the bank that sent out monthly statements and collected mortgage payments until the loan was paid off.
Let's compare that to the mortgage business of today. Today a borrower gets a loan from a lender. Once the loan closes, the lender sells the loan to a larger financial institution. Sometimes this is Fannie and Freddie, sometimes it's some other large financial institution (think Citigroup, JP Morgan or another large, money center bank). Fannie and Freddie stood atop the financial pyramid of buying, selling and pooling mortgages. They issue the largest amount of securitzed product. They touch about 70% of all US mortgages. Both institutions have (until now) an implied governmental guarantee. That gave both institutions an incredible advantage in the market by allowing them to borrow at slightly cheaper rates then their competitors. This is how they attained top dog status in the financial world.
As mortgages moves up the food chain to larger and larger institutions these institutions "securitize" the loans, which

is a structured finance process, which involves pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors. The name "securitization" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities.

The "pooling" occurs with mortgages that have similar characteristics. For example, Fannie, Freddie or one of the larger financial institutions will take $100 million dollars of 30 year 6% mortgages that are from a geographically diverse area and "carve them up." This means they create a group of different bonds that pay principle and interest at different times to attract different types of investors. The securitization process has been around for about 30 years or so and has been very successful
Let's review a bit. The primary difference between the old and new mortgage business is the number of financial players involved and what is eventually down with an individual loan. It use to be that a lender would hold a loan for the duration of the mortgage. Now, multiple financial players are involved and the loan is securitized, or made part of a larger pool of mortgages and then cut up into different cash flows or bonds.

What went wrong

The Treasury's Bail-Out Plan: An Overview And Why Now?

It’s official: the US government is bailing out Fannie Mae and Freddie Mac. Over the last 24 hours there have been a lot of stories and a lot of analysis of the situation. I would encourage everyone to read as much of this as possible; this is one of the most important developments in the financial markets in the last 30 years (if not the most important).

Here is a link to Paulson’s complete statement.
Let’s go through some of the points in detail.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

In short, Fannie and Freddie will grow a bit and then become far more manageable from a size perspective. This is a very sound policy, if only to prevent a bail-out of mammoth proportions from having to occur again. It’s important to note there is no mention of where the downsizing will end – that is, will Fannie and Freddie decrease the size of their respective portfolios for two years or ten? There is no firm answer to that. I suspect that no one really knows. Instead, the players will use a "wait and see" attitude regarding this whole mess.

Treasury has taken three additional steps to complement FHFA's decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.
These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

All this means is both institutions will issue a special type of security that will be sold only to the US Treasury. In return, the US Treasury will provide funding to keep Fannie and Freddie’s net worth positive. In accounting parlance, this means both will have always have more assets then liabilities. This will prevent Fannie and Freddie from having to raise capital in the financial markets. Instead, they will simply go to the Treasury.
The implied understanding with this arrangement is the currently existing common and preferred shareholders will bear the brunt of the losses because the Treasury will have a superior claim on Fannie’s and Freddie’s assets. In short, common and preferred shareholders are left holding the bag at this point.Back to the plan

Fannie and Freddie: Our Foreign Masters Have Spoken

There's one point that I think is incredibly important right now. I touch on it in the second article, but I'm not the one who presented a detailed analysis of how it happened. That distinction goes to Angry Bear:

Update: Market Watch

Consider the description of the bailout from the: New York Times:

Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan. [italics mine]

Now consider the following from MarketWatch,

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

China alone holds $376 billion in bond holdings.

Unless I am misreading something, foreign central banks will be protected, including China's...and the America taxpayer will foot that bill.

Secretary Paulson has been busy of late reassuring foreign central banks that they will be protected.

In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments.

In one such conversation, at the end of August, the Treasury sought to reassure the Bank of Mexico, according to a person familiar with the matter, of the soundness of agency securities held by the bank. Treasury officials have also had similar conversations with Japanese investors who are buyers and holders of agency debt.

.....

The meaning and ramifications of this collapse cannot be unravelled in a single post--or a hundred posts. Mismanagement, corporate greed and excess need examining.

Once again, the U.S. taxpayer will be asked to shoulder another mountain of debt. Once again, the taxpayer has become the prop of last resort as poorly managed entities become too big to fail. How long this can continue is the question.


...


And how does the next president reassure our foreign creditors that the U.S. will pay its bills?

While we may be dismayed that foreign central banks will receive "government backing," we do not have much choice.

Yu Yongding, former advisor to China's central bank, put the matter bluntly:

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

Foreign central banks have been propping up the U.S. economy:

Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

Yu Yongding is not making a threat; he is stating a fact.

If foreign central banks stop financing U.S. debt (there are no free rides), then the U.S. is in a world of hurt. As Brad Setser notes:

...in fact, the economic and financial risks that arise from the U.S. current account deficit (and the resulting dependence on foreign financing) have not been exaggerated. If anything, they have received too little attention -- and are set to grow in the coming years.

Well, "the coming years" may be sooner, not later. For the U.S., the consequences may be immediate inflation as Treasury attempts to makes its offerings more palatable. The dollar will plunge. And these are just for starters.

The party is over. Sorry that most of you working stiffs missed it. Oh, by the way, here's the bill. How did this happen?