Today the US Treasury Department and Federal Housing Finance Agency (FHFA) announced a plan to stabilize global financial markets and the U.S. housing market by temporarily taking control of Fannie Mae and Freddie Mac, the two companies that have provided nearly 80% of all U.S. mortgage financing this year.
In total, Fannie Mae and Freddie Mac have $5.4 trillion of mortgage backed securities and other debt outstanding. This is almost half of the $12 trillion in U.S. home loans outstanding, and even more sobering, this is equal to the total amount of public debt (like Treasury bonds, bills, notes) that the entire U.S. government has outstanding.
It’s being called a bailout. Treasury calls it intervention because it’s not taking the liabilities of these companies onto its balance sheet. Treasury is using taxpayer dollars to invest in the companies as needed to keep the housing market from collapsing.
WHAT HAPPENS RIGHT NOW?
On Monday and going forward, Fannie and Freddie will conduct core business as usual: they will continue buying mortgages from banks and packaging those mortgages into mortgage backed securities (MBS). This way, banks can offload loan portfolios and raise money to fund new loans, which eventually helps clear out foreclosure-driven housing inventory excess and find a pricing bottom.
The difference now is that buyers and holders of the MBS will have more confidence that Fannie & Freddie have capital to fund core business operations and thus make good on MBS coupon and principal payments. The other key difference is that Fannie and Freddie have been placed into conservatorship, which means that the FHFA, headed by James Lockhart, is now in charge. The FHFA has already replaced Fannie’s CEO with Herbert Allison, former TIAA-CREF CEO, and replaced Freddie’s CEO with David Moffett, former vice chairman of US Bancorp.
WHAT HAPPENS TO RATES?
Fannie and Freddie MBS have long been considered a stable investment for pension funds, foreign governments and other institutional investors for two reasons: (1) they are backed by real property, and (2) there has always been an assumption that the U.S. government would back them in an emergency.
It’s likely that these MBS could rally on the confirmed government backing because now they’re technically as good of a bet as U.S. public debt such as Treasury bonds. When mortgage backed bond prices rise in a rally like this, mortgage rates drop commensurately. In simple terms, this is how the rate system works for loans up to $729,750.
I am sticking with my outlook of +/- 0.25% for rates in the coming weeks. We could see an MBS rally and push rates down. But we could also see broader stock markets rally on the Fannie/Freddie news which would take money away from MBS, pushing MBS prices down and rates up. My weekly rate reports will monitor how this plays out.
WHAT HAPPENS TO TAXPAYERS?
The real losers here are existing Fannie & Freddie shareholders. They’ve already lost big as share prices dropped in anticipation of this intervention. Common and preferred shares will remain outstanding but these shareholders will lose stock dividends which were eliminated under this plan.
Treasury can use taxpayer dollars to buy up to $100 billion of senior Fannie/Freddie preferred stock, and also purchase Fannie/Freddie MBS in the open market. Effective immediately, taxpayer dollars will be used to buy $1 billion in senior preferred stock which pays 10% per year coupon payment starting in 2010, and gives the government control of 79.9% of the companies. Also this month, Treasury will buy $5 billion of Fannie/Freddie MBS to prove to markets that this is quality paper that’s safe enough for our tax dollars.
Basically the Treasury is using our tax money to invest in the success of companies that ultimately back the value of the homes we own.
On a side-note that maybe goes beyond what consumers care about, Fannie/Freddie will continue to make principal and interest payments on their $19 billion in subordinated debt. This is a huge deal because if they defaulted, it would have caused a global spiral of credit default insurance payouts and losses. Nobody knows how much, but $62 trillion of credit default insurance was written on all types of debt through 2007—this is four times larger than the U.S. stock market. This alone helps avert a financial market disaster.
WHAT IS THE ENDGAME?
Treasury Secretary Henry Paulson and FHFA Lockhart both acknowledged that for Fannie/Freddie to have public mission (market liquidity) and a responsibility to shareholders (for-profit companies) is an “inherent conflict and flawed business model” that needs to be rectified. FHFA and Congress will be on the hook for this.
The most likely outcome is that the companies will be broken up. Parts will be privatized and parts will be absorbed into other agencies like the FHA. That is long-term. This plan was not intended to address the endgame. It was an effort to gain some financial and housing market stability, eventually shrink the MBS portfolios of these companies, and make them manageable enough to break up and sell off.