After months of stock price declines and financial market troubles, Fannie Mae and Freddie Mac will be taken over by the federal government.
The cost to taxpayers of such a plan to bail out and recapitalize the mortgage finance giants Fannie Mae and Freddie Mac will ultimately hinge on how quickly the country's housing market recovers from its currently unstable condition that continues to see record rates of house-price declines and foreclosures, according to government officials.
On Sunday morning, the U.S. Treasury Department and the Federal Housing Finance Agency (FHFA) presented details for a joint plan that calls for the financially beleaguered Fannie and Freddie to be placed into a conservatorship controlled by FHFA. Treasury would buy hundreds of billions of dollars worth of the companies’ stock and provide additional secured short-term funding to both companies and 12 federal home-loan banks to purchase mortgage-backed debt in the open market.
Daniel Mudd and Richard Syron, Fannie's and Freddie’s CEOs, respectively, have been replaced by Herbert Allison, the former chief executive officer of TIAA-Cref, a huge teachers’ pension fund; and Daniel Moffett, who was vice chairman of US Bancorp and a senior advisor to the Carlyle Group.
Treasury Secretary Henry Paulson explained that the takeover of the two government-sponsored enterprises—which currently own or guarantee $5.4 trillion of the $12 trillion in home loans outstanding and guarantee about 70 percent of all new loans—was imperative because they had become so large “and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.” James Lockhart, FHFA’s director, added that Fannie and Freddie have been “overwhelmed” by market conditions. “Unfortunately, as house prices, earnings and capital have continued to deteriorate, their ability to fulfill their mission has deteriorated,” he stated.
Paulson added that Fannie and Freddie are “crucial" to any housing turnaround. “Our economy and our markets will not recover until the bulk of this housing correction is behind us." The implication of Paulson's and Lockhart's comments was clear: the takeover plan represents the government’s attempt to create an environment where banks and investors are willing to extend capital to Fannie and Freddie in ways that would stabilize the housing and credit markets.
The initial reaction to this plan by some experts quoted in various news reports was that it could help homeowners by lowering borrowing rates, which have been steadily creeping upward. The plan breaks down into several components, each designed to re-establish Fannie and Freddie’s financial soundness.
• FHFA and Treasury would have the authority to purchase billions of dollars in mortgage-backed securities from Fannie and Freddie on the open market and from a lender through Treasury from a general fund held at the Federal Reserve Bank in New York. Treasury will also create a back-up source of borrowing to be used in the event that Fannie or Freddie can’t borrow enough money on their own to finance the buying of mortgages and reselling them as pools of mortgage-backed securities. Yesterday, Ben Bernanke, chairman of the U.S. Federal Reserve, lent his full support to the plan. “These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets,” his statement read.
• Under the plan, Treasury would receive $1 billion in senior preferred notes, with warrants representing ownership of 79.9 percent of Fannie and Freddie. In exchange, Treasury would provide as much capital as needed through the purchase of up to $100 billion of each company's preferred stock to keep Fannie and Freddie's capital reserves from falling below levels that would force them into receivership. The government would receive annual interest payments of 10 percent on its initial investment. By ensuring that both enterprises maintain positive net worth, the government said it was providing “security”and “confidence” to investors holding bonds and mortgage-backed debt. As of June 30, Fannie had $47 billion in capital and Freddie had $37.1 billion. (The takeover decision, in fact, was made after Treasury retained Morgan Stanley to scrutinize both companies' books, and its probe found that Freddie and to a lesser extent Fannie had overstated the value of their reserves by not marking down the value of subprime and Alt-A loans in their portfolios to current market prices. Treasury won't need to write down those loans because it intends to hold onto them through maturity.)
• The bailout is contingent upon Fannie and Freddie reducing their portfolios. This is a bit tricky because the plan allows both companies to increase their holdings of mortgages and securities until the end of next year. However, the plan specifically calls for their portfolios, which now stand at around $1.4 trillion in aggregate, to decline to $850 billion by Dec. 30, 2009, and to be reduced at a rate of 10 percent annually starting in 2010 until each entity’s portfolio is winnowed to $250 billion.
• Shareholders take it on the chin in this plan. Fannie’s share price is already down 66 percent this year, and Freddie’s has dropped 69 percent. Under the takeover plan, dividends for both companies’ preferred and common stock would be eliminated, even as the stocks remain outstanding. Common shareholders would be placed at the end of the line for any claims on the enterprises’ assets, and preferred shareholders would fall back to next to last in line. On the other hand, the conservatorship would continue to make principal and interest payments on the companies’ subordinated debt. On Sunday, Standard & Poor's issued a statement that the nation's AAA/A-1+ sovereign credit rating would not be affected by the takeover of the two firms. However, S&P lowered its ratings for Fannie and Freddie’s preferred stock to non-investment grade.
This bailout plan emerges only six months after the Fed stepped in to rescue Bear Stearns by arranging its acquisition by JPMorgan Chase. Only time will tell how much money the federal government will need to inject to prop up this conservatorship. But it’s worth recalling that the savings and loan debacle in the 1980s and early 1990s cost taxpayers $124 billion, plus another $30 billion contributed by the banking industry, according to Bert Ely, a banking consultant and critic of the enterprises, whom the New York Times quoted yesterday. But something dramatic on the part of the government has seemed inevitable for a while, as the latest credit crisis, which has gone on for more than a year, had caused more than $500 billion in losses and writedowns, according to Bloomberg News.
John Caulfield is a senior editor at BUILDER magazine.