July 21, 2008 – Page 1970
Whatever is to become of Fannie Mae and Freddie Mac? For 40 years they have existed uneasily in the vague netherworld between publicly traded companies subject to the whims of investors and government agencies backed by taxpayers.
No longer.
Treasury Secretary
This shift came in dramatic fashion on a Sunday afternoon on the steps of the Treasury Department, in an announcement timed to get maximum attention as financial markets across the Pacific were waking up. Paulson said the Bush administration wants virtually unlimited authority to lend money to these two enterprises, and even to buy their stock. Almost simultaneously, the Federal Reserve Board of Governors voted to give Fannie and Freddie open-ended lines of credit as a bridge until Congress grants Paulson’s request, which it now seems certain to do as part of a sweeping foreclosure relief bill that is headed for enactment.
It was a special moment of vindication for longtime critics of Fannie and Freddie’s special status, who roared that it was proof taxpayers would be put on the hook if ever it appears that the two companies and their $1.5 trillion in outstanding debt are in danger of failure. And it produced a sigh of relief among those who support them and fear for the stability of the economy as a whole if their survival is called into doubt.
Fannie and Freddie are two of the most ubiquitous players in global financial markets, and they play a central role — some say too central — in the availability of credit to homebuyers trying to live the American Dream.
They own or guarantee $5 trillion worth of residential mortgages — an amount roughly equal to the total federal government debt traded on Wall Street — out of roughly $12 trillion in home loans nationwide. They hold on to some of the loans they purchase from banks, thrifts and free-standing mortgage lenders, and others they assemble into so-called mortgage-backed securities — special securities they sell to the public that are backed by mortgages — that are then sold to pension funds, insurance companies and foreign governments that want a steady income from payments on home loans. Virtually every week these two behemoths borrow billions of dollars so they can buy new mortgages and keep cash flowing in that marketplace.
The question for lawmakers and administration officials is whether these two enterprises ultimately should be folded back into the government that created them, or be cut loose from all taxpayer-financed ties.
Despite protests to the contrary from Paulson and from the congressional friends of Fannie and Freddie, lawmakers and administration officials who are working on the issue are acutely aware that these enterprises are too large and too tied to taxpayers to retain their current status for very long without facing the possibility of another meltdown like the current crisis.
“The current structure, if it’s perpetuated, could survive for a long, long time, but it’s an accident waiting to happen again,” said Robert Litan, a senior fellow at the Brookings Institution and vice president of research and policy at the Kauffman Foundation in Kansas City, Mo.
The Treasury’s proposal has all the earmarks of a temporary solution intended to prevent an immediate collapse of these companies and the mortgage market that they dominate. Eventually, Congress will have to choose one path or the other, though when that decision might be made — or forced — is at the moment unknown.
Fed Chairman Ben S. Bernanke came close to conceding the point in testimony to Congress last week. Pressed about the future of Fannie and Freddie, Bernanke was candid. “There are certainly a number of different possibilities, rising from outright nationalization to privatization and breaking them up,” he said before falling back to the formulation that both he and Paulson used for much of the week to explain their intentions. “In the near term, thinking about the needs of the housing market, I think the right solution is to keep them in their current form, but to provide very strong oversight that will ensure adequate capital going forward,” Bernanke said.
Those were very close to exactly the same words that Paulson used to explain why he and the administration want to preserve Fannie and Freddie as “shareholder-owned” companies. “We have no intent to nationalize,” Paulson told lawmakers, and he sparred with those who doubted him.
The first question is whether it’s already happened: Even if officials and lawmakers are not saying so overtly, the two companies were, in effect, nationalized at the moment of Paulson’s announcement. Even if the liabilities of these two enterprises haven’t been moved onto the government’s books, there is no doubt that the implicit government guarantee that has existed for four decades suddenly became explicit.
“There was always the view, certainly by many, that Fannie and Freddie were relatives of the U.S. government, if they weren’t direct descendents,” said
By many measures, how the government proposes to shore up Fannie and Freddie looks nothing like the controversial and sometimes-expensive bailouts of the past. The slow-motion collapse of hundreds of savings and loan institutions in the late 1980s and early 1990s cost taxpayers roughly $125 billion and the industry itself an additional $25 billion in salvage costs. But that happened over a period of several years. Congressionally approved federal government loans made more than a generation ago to Lockheed Aircraft Corp., Chrysler Corp. and New York City amounted to billions of dollars at the time, but wound up costing taxpayers nothing because they were repaid with interest.
And, at the moment, this latest action doesn’t come close to resembling the rescue of Bear Stearns Cos. earlier this year before it could collapse and take down any of its Wall Street cousins. That involved an immediate $30 billion loan from the Federal Reserve. As of yet, however, not a dime has been handed to Fannie and Freddie by the Fed or the Treasury.
How this all plays out is likely to depend on what happens in the mortgage and stock markets in coming weeks, as Congress debates the Treasury plan and whether an actual monetary rescue is required.
The very announcement of the administration’s proposal reassured those who routinely lend to Fannie and Freddie, and last week Freddie was able to borrow $3 billion in credit markets using two-year notes that carried only a slightly higher interest rate than the company had paid for similar notes a few weeks earlier. Also, credit-rating companies reaffirmed that the notes have the highest possible AAA grade, mostly because the government guarantee has become more explicit.
Stock investors were less sure. A precipitous fall in share prices that cut the market value of the two companies in half during the week before Paulson’s announcement had prompted the government to act. The price per share for both companies, which had exceeded $60 a year ago and $20 a month ago, dropped to $10 for Fannie and less than $8 for Freddie before the Paulson plan was announced. They fell a bit further during the first part of last week, but the decline eventually braked, and both stocks ended the week with slight gains, suggesting that investors wanted to wait and see if the administration’s rescue worked. But it’s likely that the risk the government might take the companies over — a step that almost assuredly would wipe out shareholder value — prevented share prices from rising very far.
Judging from the prominence of their advertising — Fannie and Freddie promotions can be found routinely both in magazines and on television — it may come as a surprise to most Americans that the two companies don’t themselves make loans. Regardless, it’s hard to dispute the idea that the cheap financing they provide has made it possible for 68 percent of American households to own their homes.
But this benefit to individuals came at an enormous risk to the economy, as the two companies almost tripled in size over the past decade. Although they were put under the supervision of a new regulator in 1993 and had to meet capital requirements for the first time, in the eyes of many observers Congress left that regulator without the tools to do the job. It “was deliberately set up to be weak,” said Richard S. Carnell, a Fordham University law professor and former assistant secretary of the Treasury for financial institutions under President Bill Clinton.
The risk became all too real when shares in Fannie and Freddie slumped. The panicked selling and a fear that the companies would be unable to raise capital in the marketplace led Paulson to the steps of the Treasury.
Given Fannie and Freddie’s unique size and structure and their fundamental involvement in the U.S. and global economies, the Treasury and the Fed had little choice but to take action. And that urgency has also driven the congressional response, which amounts to a desire to prevent their collapse first and to think later about what happens next.
“There’s nothing I know of in my 27 years that comes close to this situation” is how Connecticut Democrat
Fannie and Freddie are two of a small handful of so-called government-sponsored enterprises, or GSEs, entities created by Congress that on one level act like ordinary companies and on another serve a governmental purpose to provide credit to homeowners, farmers and food producers. For at least 20 years, a usually low-key debate in Washington has focused on whether these GSEs properly exist.
To some, the functions of these quasi-governmental entities pose a danger to taxpayers because of their special connection to Congress. Critics of the status quo say these credit functions would best be handed off to companies completely separate from government. To others, the GSEs might as well be converted into federal government agencies. Several of these government-sponsored enterprises have had their government ties severed in the past. And a few have received government bailouts when they got into financial trouble.
On Capitol Hill, lawmakers from both parties are wary of extending a blank check to the Treasury, worrying that it would exacerbate the risk that taxpayers will wind up on the hook. Some suggest tying the proposal to the statutory ceiling on the government’s overall debt.
Republicans tend to be much more skittish overall about the consequences of the rescue plan. Democrats, on the other hand, tend to be close allies of the two companies and have been more supportive of Paulson’s ideas. They value the ability of Fannie and Freddie to provide relatively low-cost mortgages, and they like the idea of tapping the earnings of these companies to subsidize affordable housing for those who couldn’t otherwise buy a house.
“I think, given the importance of these institutions, particularly at a time when the private market, having made a lot of serious mistakes in the mortgage area, has sort of dried up in response, I think it is important to keep them going,” Frank said July 14 on PBS’s NewsHour with Jim Lehrer.
At bottom, it’s easy to see why Frank and many others are concerned. Fannie and Freddie are two of the largest financial companies in the world. Not only do they hold two out of every five mortgages, they dominate the market in so-called conventional loans — those that have traditional underwriting standards, that require down payments from homebuyers, that tend to be smaller and that generally have low rates of default. In the current climate of tight credit and worried investors, however, the problem that began with more questionable subprime loans has spilled over onto their books.
The drop in the stock prices for Fannie and Freddie has already wiped out almost 90 percent of their market capitalization. In May, Fannie reported a loss of $2.2 billion for the first quarter of this year. Freddie reported a much smaller loss of $151 million, but investors didn’t see that as a particularly silver lining in the otherwise-gathering clouds.
Analysts and investors were worried that the two companies might not have sufficient reserves to weather additional losses, even though the companies themselves and their government regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, insisted that they were well capitalized.
The fact that Fannie and Freddie have borrowed more than $750 billion each to finance their operations — much of it short-term loans that regularly have to be rolled over with new borrowing — made worries about investor confidence all the more acute.
Frank is among those who have protested loudly that the two companies aren’t to be blamed for their current troubles. “I don’t think either one of these institutions is insolvent. I do think that the market has overreacted,” he said on PBS. In his view, the Treasury plan doesn’t bail out either shareholders or bondholders but, rather, protects the economy.
“It’s precisely because the private market, with this irresponsible subprime lending, has caused such difficulty that I do think a public response is necessary to alleviate the economic distress this is causing,” Frank said.
There’s also a concern that this crisis reaches beyond the United States. More than 60 percent of the two-year notes that Freddie sold last week were purchased by international investors, mostly foreign central banks. These are the same investors who routinely help finance the federal budget deficit by purchasing securities from the Treasury and currently are owed about half of the federal debt.
“This debt is held all over the world,” Dodd said. “It’s not an S&L issue, this is a global one, and we need to be mindful of that.”
The notion that Fannie and Freddie are ordinary companies, subject to the same market forces that affect banks and other financial corporations, has been a bit of a subterfuge since the late 1960s. Fannie began life in 1938 as a government agency. It evolved into its status as a government-sponsored enterprise over time and was made a wholly shareholder-owned company in 1968. Freddie was created two years later as a GSE from the outset. Each has had a line of credit with the Treasury worth $2.25 billion. This “just in case” money is a benefit that no other corporation in America (other than a few other GSEs) can count upon.
The Treasury’s rescue plan extends well beyond this existing line of credit to permit an almost unlimited infusion of cash through the purchase of any asset the two companies own — mortgages, mortgage-backed securities, or even shares of common or preferred stock.
Economists and other analysts have long contended that the two companies’ lines of credit at the Treasury gave them an unfair advantage when they borrow, and, in fact, Fannie and Freddie have generally paid interest rates not considerably higher than those paid by the Treasury.
That, in turn, has given Fannie and Freddie a near-monopoly for those parts of the mortgage industry in which they are involved, because no one else could match their ability to borrow cheaply. No companies that must borrow at market rates to buy mortgages — the principal business of Fannie and Freddie — could match them in price. They profit by paying less for the money they use to buy mortgage loans than they earn in interest on those loans, and by charging fees to package loans into the mortgage-backed securities that they sell to other investors.
And their economic advantage has allowed them to buy about 80 percent of all conventional mortgages this year, those that carry the least risk and are the most profitable.
Many lawmakers would argue with the assessment that Fannie and Freddie have already been effectively nationalized — which would constitute an admission that all of their financial liabilities rest on the full faith and credit of the federal government, and if any were allowed to default it would be a stain on the Treasury’s otherwise-pristine credit rating.
A true nationalization would involve having the government take control of the companies, wiping out the existing shareholders.
Fannie and Freddie could be converted into government agencies, virtually indistinguishable from those that promote health and welfare — except for the large amount of debt that they hold. But some existing government agencies already act in some ways like Fannie and Freddie, notably the Government National Mortgage Association, or Ginnie Mae, which guarantees some mortgage-backed securities but doesn’t buy loans or actually issue such securities.
Even some critics of Fannie and Freddie see merit in at least debating true nationalization of these enterprises.
“They all started as government entities,” said Jim Leach, an Iowa Republican who was chairman of the House Banking Committee from 1995 until 2001 and worked for years — mostly without success — to increase regulation of the two GSEs. “Fannie and Freddie were government entities that became privatized, so you can immediately move them back into becoming a government entity,” Leach said.
Others defend efforts to shore up Fannie and Freddie’s finances precisely to avoid putting their trillions of dollars of mortgage guarantees and outright debts directly on the government’s books. That’s because to do so would essentially increase the federal debt overnight to almost $15 trillion from the $9.5 trillion official tally today.
“We don’t want them to fail because we don’t want to nationalize them,” said
Most experts concede that to realistically bring these two companies inside the government would first require that they be restructured to shrink the size of their portfolios and to greatly limit the liabilities that would then become the government’s.
That possibility exists, however, because Congress has been moving forward with a foreclosure relief bill that would establish a new regulator for the two companies to replace OFHEO, which has been in existence since 1992 and is widely regarded as too weak. Lawmakers intend to attach the rescue plan to this foreclosure and regulatory measure, which may become law soon.
The intention is that this new regulator would impose stiffer capital requirements on Fannie and Freddie and restraints on their ability to grow. If that should happen, then talk of nationalization might be timely, said Peter J. Wallison, a one-time Treasury official and White House counsel who is now a senior fellow at the American Enterprise Institute. Still, that could take years.
“I do think nationalization becomes possible when they have become much smaller institutions,” Wallison said. “It depends on how they are regulated from this point on under the new regulator.”
True conversion of these companies to agencies would solve one other problem: Congress could continue to use them to fulfill social goals, such as financing low-income housing.
“Then, the debate will be, well, we need someone to come in and exercise government policies in the housing area in the way a private property-making organization cannot,” Wallison said. “We accept your argument that you can’t force a private sector organization to carry out these responsibilities, so let’s nationalize them. If they’re small enough, that would make some sense.”
In the alternative, a nationalized Fannie and Freddie might be kept a bit more at arm’s length from the rest of the government for a time with the expectation that they would be sold back to shareholders at some point in the future.
Eliminating government support for Fannie and Freddie is an appealing idea to Wallison, and to many other opponents of the current system. But it would require that Fannie and Freddie be shrunk and divided many times both to generate competition and to avoid the risk that — like Bear Stearns — the new company might one day be in need of a bailout.
“You’d have to break them up into pieces so that no one of the pieces is too big to fail,” Litan of Brookings said.
It would make sense to try, said Fordham’s Carnell. “Experience shows we do not need a GSE to be doing these things,” he said. “This bailout has also resolved all of the remaining ambiguity about government-sponsored enterprises.”
As Wallison noted, eliminating the government’s ties to Fannie and Freddie might present a conflict with the public purpose that these enterprises were created to serve. Congress has often dictated to Fannie and Freddie how they must do their jobs. Even in the pending foreclosure relief bill, lawmakers would expand the limits on conforming loans so that Fannie and Freddie can participate in higher-income neighborhoods. And they would siphon off a portion of the two companies’ profits to finance affordable-housing programs and give strapped homeowners assistance to avoid foreclosure.
And Litan conceded that the politics of breaking Fannie and Freddie into many pieces to be sold off are problematic.
But these times may not require such a close connection between policy and the allocation of credit, several experts said. “The value they played in those early days cannot be overestimated in making homeownership a reality for over half of all Americans,” said Baker, the former lawmaker from Louisiana. “But financial markets have developed in incredible ways, and there are any number of sources of credit for home mortgages.”
For his part, Wallison said he expects the time isn’t far off when there will be a “healthy debate” over preserving the status quo for Fannie and Freddie under a new regulator with new powers and shrinking them and cutting them loose.
Most observers on all sides of this issue see the Treasury bailout as an essential step to staving off a bigger crisis. And most are banking on the new regulator to give them some breathing room to think about the blueprint for how Fannie and Freddie should operate in the future.
“You’ll have a very tough regulator who will have all kinds of powers,” said Frank, who said he favors seeing Fannie and Freddie operate under tighter supervision. “Yes, they may not change immediately, but they will be operating in a very different regulatory structure.”
For one thing, the new regulator will have the authority that OFHEO does not to put Fannie or Freddie into receivership — take them over — if they fall into a financial hole again. That change alone would alter the relationship between the two companies and their shareholders, and it would open the door to changing their organizational makeup.
There is also recent precedent for a government takeover of a private company, running it for a time, and then returning it to shareholder hands. The 1984 collapse of Continental Illinois National Bank and Trust Co. resulted in a takeover by the Federal Deposit Insurance Corporation. The FDIC ran Continental Illinois for seven years before selling it off.
Much of the current conversation in Washington isn’t addressing these longer-term questions. What Fannie and Freddie will truly look like in the future will have to wait for another day.
For now, throwing government resources into the mix to prevent them from falling off a cliff seems prudent, said Baker. “We can’t deny that this kid is ours,” he said. “He may have gotten a speeding ticket, he may have gotten a DWI, he may not have finished high school and he may have no job skills, but we’ve got to shape him up.”
Continuing the analogy, Baker said there may be time to push the ne’er-do-well offspring out onto his own, if under closer supervision he cleans up his act. “If he can navigate a job and show up on time, then we can talk about it,” Baker said.
Benton Ives, Phil Mattingly and Clea Benson provided reporting for this story.
FOR FURTHER READING: Foreclosure relief bill (