Freddie Mac (FRE) and Fannie Mae (FNM), the two largest mortgage finance companies, have witnessed their share prices plummet more than 80 percent from a year ago, representing a decline in shareholder value of approximately $100 billion. This collapse was driven by eroding investor confidence in Fannie and Freddie’s financial stability in the wake of the severe housing slump and amid concerns that the government will take them over. Recently, the U.S. Treasury, in an attempt to calm jittery markets, announced that it would shore up the two firms’ finances if they needed help in what would be the biggest bailout in history. Henry Paulson, U.S. Treasury Secretary stated that the government’s focus is in supporting Fannie Mae and Freddie Mac in their current form. To put this into perspective, a full bailout could cost taxpayers as much as the Iraq War, or more.

Over the past three years, Freddie and Fannie have played pivotal roles in keeping the mortgage markets afloat as credit markets have dried up. Together, they are the largest buyers of home loans in the U.S., holding or guaranteeing approximately $5.2 trillion worth of mortgages, representing approximately one-half of the country’s $12 trillion of outstanding, home-loan debt. Almost all U.S. mortgage lenders, from huge financial institutions like Citigroup to small, local banks, rely on Fannie and Freddie.

The problem
The hybrid public-private structure of Fannie Mae and Freddie Mac creates opportunities, unfair advantages, and temptations. As government sponsored enterprises (GSEs), Fannie and Freddie have a “public service” mandate to maintain a market for mortgages, buying loans from banks, repackaging them as bonds, and selling those securities to investors with a guarantee. This makes lending more tempting for banks because Fannie and Freddie assume the interest rate and default risk. Fannie and Freddie are also publicly traded companies, with the mandate of trying to maximize profits for shareholders. With implicit government guarantees, Fannie and Freddie have enjoyed AAA credit ratings although their balance sheets would justify a much lower credit rating. As a result, both Freddie and Fannie are able to borrow at super-low rates, a benefit they used to purchase and hold high-yielding mortgage loans. The artificially fat spread between interest rates earned on mortgages and interest rates paid on bonds amounts to a big-government subsidy, which thwarts competition and undermines market discipline.

As home foreclosures continue to drive down prices, the loan portfolios continue to lose value. Although their loans are better than the subprime loans that have created much of the mortgage crisis, the problem lies in their thinly capitalized balance sheets. Fannie and Freddie do not have sufficient equity capital to survive a major downturn. Combined, they have an equity cushion of slightly over $80 billion compared to the $5.5 trillion of mortgages they either own or guarantee. Although $80 billion may seem large, a mere 2 percent decline in the value of its assets ($110 billion) would wipe out the equity. As a result, even though just a small percentage of Fannie’s and Freddie’s mortgages are delinquent, the potential losses are huge.

A fatal elixir of thin capitalization, high credit ratings, and preferential government treatment has created a system that privatizes profits but socializes losses. When Fannie and Freddie do well, their shareholders reap the benefits, but if things go badly, Washington (taxpayers) picks up the tab. If Fannie and Freddie were private companies, there would have been a natural check: companies with more debt are usually seen as riskier, and that makes shareholders and bondholders less willing to invest in them. Conversely, if they were government agencies, budget constraints would likely have limited the scope of their lending. Since neither the market nor the state checked their growth, they were able to swell extravagantly. The result of all this was that the companies reaped the rewards of the private sector while enjoying the security of the public sector.

The solution
What to do? To permit Fannie or Freddie to default would set off a worldwide crisis because the debt securities that they issue to finance their operations are widely owned by foreign governments, pension funds, mutual funds, and other institutional investors. Therefore, the imminent failure of either one would force the U.S. government to nationalize them, resulting in a doubling of the federal deficit, a futher collapse of the dollar and unthinkable implications for the U.S. Treasury’s cost of funding in the debt markets.

There are several different options that the government can take. It can nationalize them, bail them out, slowly wind them down in their present form, or privatize them altogether. These options will be subjects of future debate. SLDT