Fannie Mae and Freddie Mac: Too Big To Fail, Too Big To Bail

It was hoped by many that the testimony given before Congress yesterday would give us a clue about the government’s "implicit guarantee of Fannie Mae and Freddie Mac".  Just how good that guarantee is, is a question that cannot wait too much longer to be answered:

Gerald O’Driscoll, a fellow at the libertarian Cato Institute in Washington and a former Fed vice president, says that "sooner rather than later" the government will have to explicitly guarantee the companies’ debt to restore confidence in Fannie and Freddie. If the firms were to collapse, it would likely wreck the U.S. mortgage industry.

Testimony by Treasury Secretary Henry Paulson sounded as if Fannie and Freddie might be on their own:

"It is clear that some institutions, if they fail, can have a systemic impact." However, financial players need to be disciplined in managing risk and not expect the government to fly to their rescue, he added.

"For market discipline to effectively constrain risk, financial institutions must be allowed to fail," he said.

However, Paulson also had this to say:

The companies “are playing a very important and vital role right now,” Paulson said in testimony to the House Financial Services Committee. They “need to continue to play an important role in the future,” he said.

So perhaps Paulson means SOME financial institutions, but not necessarily Fannie And Freddie. Other testimony however, made clear that congressmen are lining up behind the GSEs:

“They must not fail,” McCain said today during a campaign stop in Belleville, Michigan. Fannie Mae and Freddie Mac “are vital to Americans’ ability to own their own homes,” he said

And from the other side of the aisle:

“Markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac,” Schumer said in a statement today. They “are too important to go under,” and Congress “will act quickly” if necessary, he said.

The question is then, just how committed is Congress to "standing by" Fannie and Freddie?  The GSEs are not easy organizations to stand by, and it’s unclear what the government can do:

The federal government can’t afford to take over all of Fannie Mae’s and Freddie Mac’s operations, because such a move would more than double federal government debt outstanding and “have disastrous consequences for the dollar,” said Joshua Rosner, an analyst with Graham Fisher & Co. Inc. in New York.

So far, help has come in the way of advice:

Fannie Mae and Freddie Mac “are well capitalized now” in “a regulatory sense,’‘[As opposed to the "staying solvent sense?"] Bernanke told the panel. Still, the companies, like all financial institutions, need “to expand their capital bases so that they can be even more proactive in providing credit and support for the economy,” the Fed chief said.

Advice that is probably easier said than done.

 

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23 Comments for this entry

  1. agnostic says:
    July 11, 2008 at 3:47 AM

    Back in the US,
    Back in the US,
    Back in the USSA.

  2. John M. says:
    July 11, 2008 at 4:11 AM

    Should be an interesting Friday.

    “U.S. Weighs Takeover of Two Mortgage Giants”, by Stephen Labaton and Steven R. Weisman, New York Times (page 1), July 11, 2008.

    Alarmed by the growing financial stress at the nation’s two largest mortgage finance companies, senior Bush administration officials are considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen, people briefed about the plan said on Thursday.

    The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

    Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

    The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt.

  3. entropy says:
    July 11, 2008 at 4:30 AM

    I think this is the day when all americans will “own” a house, unfortunately. TPTB are painted into a corner. There are no more good options left, only painful ones.

    A moral question…..What should be done about the people/corporations who made all the billions and trillions in profit?

    Should we confiscate those golden parachutes and put them towards the debt we are taking on with these bailouts?

    America…..privatize the profits, socialize the losses……what a disgrace and I love my country.

    Both political parties are responsible for the crisis we find ourselves in today.

    This is the end product of many years of poor leadership and decisions from both parties, partisan politics and personal greed.

    I guess I will vote like in 2006, anyone who is an incumbent does not get my vote, and always 3rd party if there is one available.

  4. agnostic says:
    July 11, 2008 at 4:48 AM

    entropy -

    They should be admired for their ingenuity and action, as long as they made their money inside the law.

    PS The losses should not be socialized…there was previously no explicit government guarantee, so owners of GSE debt need to take their lumps just like everyone else. It could be interesting to see the spread narrow on GSE debt today while their stocks go over the cliff.

  5. twist says:
    July 11, 2008 at 6:27 AM

    Agnostic-

    I agree- this morning could resemble Acapulco cliff diving:

    Shares of Freddie Mac dropped 35 percent and shares of Fannie Mae tumbled 27 percent in premarket trading Friday as Wall Street continued to worry about the health of the mortgage companies and the potential for a government takeover.

    "We should not be in a position that only two government-sponsored lenders are willing to make mortgage loans and, without them, our economy would collapse," Piper Jaffray analyst Robert P. Napoli said in a note to clients.

    Dow futures are way down as well.  The PPT has their work cut out for them this morning.

  6. DianaK says:
    July 11, 2008 at 6:42 AM

    I really don’t think there is a choice anymore. They’ll probably be put into a conservatorship by the end of the month.

    This is not good news for anyone.

  7. twist says:
    July 11, 2008 at 6:50 AM

    Diana-

    CNBC just quoted the White House as saying Paulson will be speaking formally today about the GSEs. Unless they announce a conservatorship, I don’t see what he can say that he didn’t say yesterday.

  8. DianaK says:
    July 11, 2008 at 7:07 AM

    twist,

    I’m watching CNBC, too. I bet anything he’s going to try to calm the fears by repeating everything he’s said so far (except maybe the part about allowing some banks to fail).

    I’m not going anywhere until he speaks.

    I really just don’t see how they’ll get away with anything less. Fannie and Freddie are less than insolvent now.

    They’re like the knifecatchers last year who bought thinking they had an automatic cushion of 20% equity, then found out they’re effectively 100% borrowed, & now are realizing that they’re completely underwater & don’t know how to swim anymore.

    my word- disaster. yes, very much.

  9. twist says:
    July 11, 2008 at 7:17 AM

    Diana-

    The government is out of bullets. They can’t lower interest rates any more, and the verbal pablum isn’t working. If Paulson doesn’t have anything more substantial today, the markets will just ignore him.

    No matter what they do though, what could possibly get their stocks to rally? I, like a lot of people, would rather spend my money on lottery tickets than invest in Fannie and Freddie. [And I don't even play the lottery!]

  10. DianaK says:
    July 11, 2008 at 7:44 AM

    wow.

    the statement said nothing.

    nothing.

    what a waste of time.

  11. agnostic says:
    July 11, 2008 at 8:17 AM

    Remember, Hank believes in a strong dollar. 8)

  12. John M. says:
    July 11, 2008 at 10:40 AM

    Oh well, at least we’re getting some lively discussion on a lazy Friday afternoon in July ;)

    “Citi analysts say Fannie, Freddie selling ‘overdone’: Fear said behind mortgage giants’ recent sell-off, not their fundamentals”, by John Spence, MarketWatch, July 11, 2008.

    The Citi analysts said the recent pressure on the stocks reflect market concerns and confusion around potential for Freddie and Fannie raising additional capital that would dilute current shareholders’ positions.

    “While the question of capital adequacy has surrounded the GSEs for a while, given their relatively high leverage versus banks, the timing of recent ‘noise’ has been particularly challenging,” they said, in light of the companies’ quiet periods ahead of the release of second-quarter financial results.

  13. twist says:
    July 11, 2008 at 11:10 AM

    John-

    How do they dilute the stock when it’s trading at current levels? Do they sell zillions of shares for a quarter a piece? [U.S. or Canadian, you can take your pick.]

    If the fundamental condition of these companies is that they are “technically insolvent”, there’s a case for saying that fundamentals ARE driving the market.

    Stocks are now trading off of their lows- CNBC is saying that is because investors feel better now that Paulson is NOT pitching a bailout. I don’t see a bright picture for shareholders whatever they do.

    I also don’t see how they are going to raise additional capital. Telling the GSEs to raise capital at this point is probably like telling US to raise capital. I like the idea myself, but I doubt given the returns, that investing in a housing blog is an idea that is going to have a lot of appeal for investors- and we don’t hold billions of dollars in bad debt!

  14. John M. says:
    July 11, 2008 at 11:37 AM

    twist -

    It’s exactly the problem you cite in your title: the GSEs are too big to fail and too big to bail. Agency debt was created in 1972 in the wake of Nixon’s 15 Aug 1971 decision to close the gold window. The idea was to move all that mortgage paper away from the National Debt. In effect, this is the biggest off-balance-sheet deal in world history, and like Enron, SIVs, ABCP, etc. inevitably these things come back on balance sheet when they turn into something like this (as they always do).

    Today a lobbying group has already started calling for “Sovereign Default Lite.” It may be as early as this weekend that the Administration decides whether the title of the new 2008 horror flick will be “The Safety Net That Never Was.”

    “Chinese Government is Top Foreign Holder of Fannie Mae, Freddie Mac Bonds: $376 Billion in Chinese Agency Bond Holdings Subject to Taxpayer Bailout Proposals According to FreedomWorks Analysts”, BusinessWire / MarketWatch – source: FreedomWorks, July 11, 2008.

    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.”
    …

    FreedomWorks President Matt Kibbe commented, “The prospectus for every GSE bond clearly states that it is not backed by the United States government. That’s why investors holding agency bonds already receive a significant risk premium over Treasuries.”

    “A bailout at this stage would be the worst possible outcome for American taxpayers and mortgage holders, who have been paying a risk premium to these foreign investors. It would change the rules of the game retroactively and would directly subsidize the risks taken by sophisticated foreign investors.”

    Somehow, I doubt that Doom Castle’s new coop is going to be nearly big enough to accommodate all the chickens coming home to roost this week and next.

  15. agnostic says:
    July 11, 2008 at 12:57 PM

    So there must be a lot of soiled drawers today in China, Japan, the Cayman Islands, Luxembourg, and Belgium. A potential solution to the global fertilizer demand shortfall?

    Igor says Hank didn’t go in front of the cameras today because he was “tired” from being up 72 hours straight.

  16. John M. says:
    July 11, 2008 at 1:43 PM

    twist -

    Correct me if I’m wrong, but I thing Chris just put his foot in it:

    “Fannie Mae, Freddie Mac Are Sound; Panic Unwarranted, Dodd Says”, by Romaine Bostick, Bloomberg, July 11, 2008.

    Dodd said options for the two largest U.S. mortgage-finance companies include using the Federal Reserve’s discount window. He said the Fed and the Treasury Department are considering a “number of options.”

  17. John M. says:
    July 11, 2008 at 4:03 PM

    Well, looks like the SEC is going to spend the weekend investigating the Senator for blatant markets manipulation … NOT!

    “Fed: No Talks on Discount-Window Access for GSEs”, Wall Street Journal, July 11, 2008, 4:51 pm [which is to say after NY Markets have closed for the week]

    Federal Reserve officials haven’t discussed discount-window access with government-sponsored enterprises Fannie Mae and Freddie Mac, a Fed spokeswoman said Friday.

    “Federal Reserve officials are following the situation closely, but there have been no discussions with the GSEs about access to the discount window,” Fed spokeswoman Michelle Smith said when asked about a report that Fed Chairman Ben Bernanke had told Freddie Mac’s chief executive that the GSEs were eligible to use the facility.

    Igor says, “trickery.” (how does he do that anyway …)

  18. John M. says:
    July 11, 2008 at 4:14 PM

    OK, I give up :(

    “Oil over $147 on Fannie and Freddie fears”, by Kristina Cooke, Reuters, July 11, 2008.

  19. John M. says:
    July 11, 2008 at 5:58 PM

    Well, obviously the WSJ story in #17 hasn’t filtered to London yet. But old Doom friend Chris Whalen has some amusing thoughts on it all.

    “President Bush moves in as Fannie Mae and Freddie Mac lose value”, by Tom Bawden, The Times, July 12, 2008.

    The shares did regain some lost ground, as it emerged that Mr Bernanke, the US treasury secretary, was seriously considering extending his central bank’s “discount window” of cheap financing to the two groups to help plug their balance sheet gaps, as an alternative to backing them.
    …

    Chris Whalen, of Institutional Risk Analytics, added: “If people thought for a moment that the US central bank would not ultimately stand behind Fannie and Freddie then the entire US financial system would collapse.”

    Mr Whalen forecasts that the US Government will eventually renationalise both groups and merge them. The combined entity would find it easier to raise the money needed to fund the tens of billions of dollars of losses they are collectively expected to suffer from the credit crunch if it had the backing of the taxpayer, Mr Whalen said.

    Even if the Government does not end up rescuing Freddie and Fannie, their shareholders feel doomed. Analysts believe that the two enterprises are so thinly capitalised that they could not possibly raise the capital they need to survive if they continue as public companies.

  20. John M. says:
    July 11, 2008 at 6:25 PM

    Your PPT dollars at work ;)

    “Fannie, Freddie Worries Drive Down Markets”, by Renae Merle, Washington Post Staff Writer, Saturday, July 12, 2008; Page D01.

    The Dow Jones industrial average spent most of the day down more than 200 points, falling below 11,000 twice. The market sprinted back into positive range at about 3 p.m., when some news outlets reported that Fannie and Freddie, which have sustained significant loses related to the mortgage crisis, would be allowed to borrow from the Federal Reserve’s discount window. When the Fed did not confirm the move, trading fell back into negative territory to close the day.

  21. twist says:
    July 11, 2008 at 7:36 PM

    John- #20

    The PPT pulled it off better than I thought they would- but so far, after hours for the Dow, FNM and FRE look terrible. They are definitely in for a long weekend.

  22. billydlight says:
    July 11, 2008 at 10:41 PM

    Despite what you may have been hearing in the media, there are still many different loan options and selection has never been better! Call your(Max Headroom stutter) Re-Re-recycle-realtor today! B-b-buy now, p-p-pay later!
    Ask not what your country can do for you but what you can do for your Co-co-corprate Congressman! Burn your cash, sa-save on inflation! Millions on welfare still depend on you going to w-w-work!

  23. JimAtLaw says:
    July 12, 2008 at 8:27 AM

    Ouch Billy. The truth hurts.

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