Fannie Mae (FNM) and Freddie Mac (FRE), the now infamous mortgage finance companies, have witnessed their share prices plummet more than 98 percent from a year ago. Eroding investor confidence stemming from the faltering U.S. housing market and the subprime mortgage crisis drove the share prices of these two former mortgage giants under a dollar. By late August 2008, concerns about Fannie and Freddie’s financial stability had reached critical levels. More importantly, the anticipated disastrous impact on the global economy from a failure of either entity made it evident that something had to be done in order to stave off an even bigger crisis. On September 7, 2008, the Bush administration seized control of the two companies, placing them in a government conservatorship.

The rescue package, which could become the most expensive financial bailout in American history, was deemed necessary to prevent further turmoil in the financial markets and provide some relief to the crippled housing market.

Fannie and Freddie 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.

Fannie and Freddie raise cash to buy mortgages from lenders by selling bonds, and either hold them in their portfolios or pool them together as mortgage backed securities for sale to investors. By linking mortgage lenders with investors, the two firms keep the supply of money widely available and at a lower cost. The problem is that they guarantee all the loans that they sell to investors, so if a homeowner defaults on a loan, Fannie and Freddie will step in and make good on the loan. As a result of increasing numbers of defaults and foreclosures, they have lost approximately $11 billion in recent months with the expectation by many that the worst is yet to come. Most experts agree that the failure of one or both of these entities would send the financial system and the overall economy into a tailspin.

Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt’s New Deal. The collapse of the national housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.
Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. This led to the development of what is now known as the secondary mortgage market. Within the secondary mortgage market, companies such as Fannie Mae are able to borrow money from foreign investors at low interest rates because of the financial support that they receive from the U.S. Government. It is this ability to borrow at low rates that allows Fannie Mae to provide fixed interest rate mortgages with low down payments to home buyers. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge.

For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market. In 1968, due to fiscal pressures created by the Vietnam War, Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. At that point, Fannie Mae began operating as a government-sponsored enterprise (GSE); generating profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing. In order to prevent any further monopolization of the market, a second GSE known as the Federal Home Loan Mortgage Corp., or Freddie Mac, was created in 1970.

Up until that time, the home mortgage industry was characterized by regional variations in interest rates and lending criteria that made it difficult for some consumers to obtain home loans. Because of their GSE status, although the two companies are publicly traded on the NYSE, they are protected financially by the support of the Federal Government. These government protections include access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight.

Repeating History in a Boom-Bust Cycle
In pursuit of a construction boom during the 1980s, real estate financing by commercial banks grew rapidly to meet the demand because deregulation and other factors created an environment in which real estate lending was very lucrative for lenders. Competition among banks created a strong incentive to lessen underwriting standards. In addition, overly optimistic appraisals combined with relaxation of debt coverage (i.e. reduction in the maximum loan-to-value ratios) and the loosening of other underwriting constraints meant that borrowers had little or no equity at risk, putting the vast majority of the risk on the lender.

The problem with this scenario is that the real estate market is, by nature, cyclical. Construction booms often leads to overbuilding and when the bubble bursts, real estate values decline sharply putting loan quality at risk. Because real estate projects are so highly leveraged (funded primarily by debt as opposed to equity capital by the investor), they are highly sensitive to changes in interest rates and overall credit and macroeconomic conditions.

The problem is compounded when commercial banks tighten their belts to protect their already deteriorating balance sheets. Because real estate value is sensitive to the availability of credit, when financial institutions restrict lending, prices of existing properties fluctuate widely and the volume of new investments can be severely affected.

If this scenario sounds all too familiar, it should. The main difference between the 1980s and now is that they didn’t repackage risky mortgages into leveraged financial instruments (e.g. CDOs and MBSs) “guaranteed” by credit default swaps (CDSs) and sell them around the world.

The Current Problem
The hybrid, public-private structure of Fannie Mae and Freddie Mac creates opportunities, unfair advantages, and temptations. As 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 Fannie and Freddie 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, thwarting competition and undermining 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 Future
This financial bailout passed by Congress, estimated to cost anywhere between $25 billion and $50 billion, is expected to stabilize the financial markets and, it is hoped, that propping up Fannie and Freddie will help pull the housing market out of its slump. By explicitly standing behind their debts, it is expected that the wide premium over Treasury bills that Fannie and Freddie securities currently trade at will shrink. According to some estimates, reducing this interest rate premium by one percentage point could reduce the effective cost of buying a home by as much as 15 percent. The money from the Treasury Department will be used to strengthen the companies’ balance sheets and shield them from insolvency. The “pro” of such a quick-fix bailout attempt would be the immediate stabilization of the markets, with the “con” being that reconstituting them in the same flawed structure may lead to a repeat performance.

In their present forms, Fannie Mae and Freddie Mac have outlived their useful purpose. Today’s housing market bears little resemblance to that of the Depression, when Fannie Mae was first chartered, or even 1968 when it ceased to be a government agency and became a GSE. For this reason, some critics believe that Congress should, instead of throwing them a lifeline, begin to slowly shrink these specially privileged GSEs. These entities were created for the purpose of greasing the Depression-era mortgage business for low-income home buyers by repackaging loans as securities. As it stands now, Fannie and Freddie have gone way beyond helping the poor and are now backing loans for the wealthy.

Fannie and Freddie are not essential to the mortgage market, and if they were wound down in an orderly process over a number of years, the market would pick up the business that they left behind. As a result, many feel that Congress should maintain their GSE status but downsize Fannie and Freddie to minor roles strictly for the poor, for which they were originally designed. The “pro” of such an orderly wind down would be an organized process of deleveraging without suffering from a massive and severe system shock with the “con” being that although smaller, the GSE status still grants all kinds of federal advantages, hindering free market competition, and setting taxpayers up for another meltdown in the future.

Those holding more progressive opinions argue that Congress should go the extra mile once the immediate crisis is over and fully privatize them1, stripping their GSE status and the accompanying legal restrictions on the diversity of their investments, so that they would be subject to unfettered market competition. Normal markets must allow faulty businesses to fail, as demanded by the tenants of capitalism. Clearly, that is not the case with these two hybrid public-private entities. Additionally, it is dangerous to maintain such a large role in any market for only two operators.

Like any other private-sector corporation in financial peril, once these entities are privatized and stripped of their special privileges and federal loan guarantees, they should be forced to sell assets, raise capital, and reduce debt. Once they have been downsized and deleveraged, the market will determine their fate. The “pro” of immediate privatization would be the elimination of privileged and potentially toxic GSE mortgage companies with the “con” being a massive market adjustment that may wreak havoc on the mortgage market over the next few years.

Considering the aforementioned “pros” and “cons”, the best solution may be a combination of the prior two suggestions. In other words, it may be most prudent to gradually reduce them to a more comfortable level and at that point, removing the GSE status and let the chips fall where they may.

Regardless of whether Fannie and Freddie retain their GSE status, the commercial and residential real estate markets will face real challenges over the next several years due to the “perfect storm” which are now facing. We are currently witnessing unprecedented business failures and forced consolidations on Wall Street that are leaving investors around the world wondering what the next day will bring. Despite the doom and gloom, Americans are traditionally optimistic and determined, and understand that however bad things seem on Wall Street and “Main Street,” this storm will pass. Lack of available credit will dry up real estate development, which should allow demand to catch up to supply. Increased regulations coupled with tighter lending and underwriting standards will bring discipline to the market. Eventually, supply and demand fundamentals in the housing and commercial real estate markets will converge and the markets will recover, albeit slowly.

Predicting the Future of Fannie and Freddie Based on Politics
Since the election of Obama/Biden, it is likely, in our opinion that Fannie and Freddie will continue to receive special treatment under the GSE status. Despite the best efforts of Democrats in Congress over the last ten years to relax regulations for the two GSEs, this is no longer a political or economic reality. It is reasonable to expect that both Fannie and Freddie will be downsized over the next several years, to the point that they will no longer represent a systemic risk to the market place. They will face very strict regulation and will likely be redirected to address the original mission of Fannie and Freddie, which was to help low income families attain a mortgage. Fannie was originally created in 1938 to save the national housing market in the wake of the Great Depression and ironically, 70 years later, the national housing market of 2008 may have just killed the former savior. SLDT
¹ There is a precedent. Sallie Mae, the student loan financing firm which was a GSE chartered as the Student Loan Marketing Association, has successfully gone through privatization — started in 1997 at its own request, including a financial mechanism through which the firm has compensated the public for the value of the taxpayer subsidy it inherited.