Monday, September 15, 2008

YOU ALWAYS WANTED KNOW ABOUT FANNIE MAE AND FREDDY MAC

Adhip Chaudhuri, Al Jazeera - Both Fannie Mae and Freddie Mac are US government "sponsored" home loan banks. Each of them have formal names, but are primarily known by their nicknames. In fact, both these institutions prefer to go by their nicknames rather than their official names. That's like the US government going by "Uncle Sam" all the time.

Fannie Mae was created by the government in 1938 to guarantee mortgage loans made by private banks. After the Great Depression, which was characterised by bank failures on the one hand, and substantial losses of income on the part of large number of households on the other, the private mortgage market was providing mortgage loans to too few households.

The objective of the Roosevelt Administration was to restore widespread homeownership, which had become almost an ideology in the United States from early on in the twentieth century.

Thirty years later, in 1968, the government freed Fannie Mae from its control and privatized it with a Congressional charter. It became just like any other bank, except that it still did not make mortgage loans directly to the public. Instead, it bought up what is called the "secondary" market - the mortgages which had already been made by the private banks.

Two years later, in 1970, the US government created Freddie Mac, an exact duplicate of Fannie Mae. The reason behind a second institution was that high economic growth of the 1960s had led to rising incomes and the resulting widespread homeownership made just one government sponsored mortgage institution, namely Fannie Mae, unappealingly, if not scarily, large.

Both Fannie Mae and Freddie Mac have been private enterprises since then, up until September 7, 2008. They have stockholders who provide the equity capital, they both sell bonds to raise funds, and they both pay for their operations out of their profits. There has been no money paid by the American taxpayers to these two institutions.

The two were "sponsored" banks, meaning that there was an implicit guarantee from the US government that it would not allow these two institutions to fail.

The principal act that Fannie Mae and Freddie Mac are mandated to do is to buy mortgages from private banks. The private banks, meanwhile, make mortgage loans with the comfort of knowing that they will be able turn around and sell those loans to Fannie Mae and Freddie Mac.

This comfort has two aspects. First, the banks which make the initial loans in the primary market get their liquidity back when they sell off their mortgages in the secondary market to Fannie Mae and Freddie Mac.

They can, therefore, make fresh mortgages to new customers with the funds they received from selling the previous mortgages, thereby making it possible for greater homeownership.

The second benefit that private banks get from the existence of Fannie Mae and Freddie Mac is that they can offer mortgages to middle class and low income households at affordable interest rates with the sure knowledge that Fannie Mae and Freddie Mac will take those mortgages over.

Where do Fannie Mae and Freddie Mac . . . raise funds first by issuing bonds on Wall Street just like any private company.

Then, in addition, they sell some of their mortgage holdings in the tertiary markets. They pool together a lot of mortgages and create a marketable security. These are called mortgage backed securities. If any household, whose mortgage is part of a MBS, fails to pay its mortgage obligation for, say, a month, then Fannie Mae or Freddie Mac, whoever is the relevant party, will make good the payment to the MBS holder.

Similarly, if there is a foreclosure and the sale price of the distress sale ends up being less than the value of the mortgage, then Fannie Mae and Freddie Mac will make up the difference.

A lot of these MBS are sold in foreign markets, especially to central banks with large US dollar holdings. The central bank of China is reputed to be holding $340 billion worth of MBS. . .

The overly aggressive primary mortgage lenders knew full well that Fannie Mae and Freddie Mac would have to buy up all the mortgages below the congressional cap of $417,000.

The primary mortgage companies get their profits from commissions and fees per mortgage that they make, and not from the repayments of principal plus interest from the mortgage borrowers, that is, the homeowner. That is why they were so reckless in their lending - it is a classic case of "moral hazard".

As the housing prices have plummeted, there have been two problems that have hurt Fannie Mae and Freddie Mac very badly. First, they have had to make increasing payments to cover the defaults in the MBS which the two institutions have sold.

Second, they have had to set aside reserves for those mortgages in their own portfolios which are "non-performing", meaning that the borrower cannot keep up with their payments. These set-aside reserves do not earn any income for the two mortgage institutions and hence, contribute to losses.

As the profitability of Fannie Mae and Freddie Mac decreased, their borrowing costs went up, squeezing the interest rate differential between what they earn from the mortgages they hold and the rate they have to pay on the bonds that they issue.

Fannie Mae and Freddie Mac did not help themselves during the crisis much either. They did not implement the guidelines they normally impose on the primary mortgage lenders, but instead they accepted many bad mortgages including "sub-prime" mortgages.

"Sub-prime" mortgages refer to those loans which were made without the necessary information on the borrowers. For example, a "sub-prime" mortgage may not require borrowers to disclose their incomes.

In addition the two institutions followed highly spurious accounting concepts to overstate their capital base. And lastly, they continued paying their top executives obscenely high salaries, even when their stock values fell by 80 per cent.

Legally speaking, the US government has put the two institutions under its "conservatorship". It's not clear what exactly does that mean.

The following is what we know now: The US government will immediately take hold of $1 billion worth of equity in each of the institutions. These will be in the form of preferred stocks with a guaranteed 10 per cent rate of return. These $1 billion infusions are however, not real cash infusions but rather, just compensation for the privilege of being expropriated by the US government.

The government has allowed itself to infuse as much as $100 billion to each of the institutions, and thus the American tax payers could be out $200 billion by the time the housing crisis plays itself out. The savings and loan crisis cost the tax payers $120 billion. Presumably, this bail-out will be less expensive.

In addition, all cash infusions by the US government will be more like an investment because they will receive a 10 per cent return. . .

The Nation - The deal stinks because it doesn't really solve anything. Fannie and Freddie executives got sacked, but nothing substantial was changed in the weirdly illegitimate structure of these private, profit-making corporations sponsored by the federal government. Instead of acting decisively, the Treasury basically opened the public's wallet and promised to spend whatever it takes to keep the companies upright. "Conservatorship" is a fiction. The taxpayers own these two high-flying turkeys in all but name because they are now picking up the tab.

A real solution to this mess is not complicated: wipe out the corporations and nationalize them, buy out the shareholders for pennies on the dollar and restore Fannie Mae to its original status as a federal housing agency (maybe merged with Freddie). Its functions involve vital public services--supporting the flow of mortgage financing, encouraging broader homeownership and subsidizing construction of low-income housing. These public goods do not much interest private financiers unless they can harvest rip-and-run profits, which is exactly what they did, with their usurious lending in the subprime mortgage scandal. . .

Instead of rescuing financial losers, the government ought to be devoting its heaviest resources to jump- starting the real economy. Instead of bailing out the money guys who caused this crisis, Washington should concentrate on bolstering enterprise, employment and productive investment.

Washington has got it backward. The financial system will not get well and return to normal lending until the economy regains its natural vigor. . .

Does Barack Obama or John McCain understand this? Neither candidate has acknowledged the enormity of what's facing the country or explained the dire implications with clarity and frankness, much less described plausible solutions. McCain is hopeless, mouthing right-wing bromides about corporate tax cuts and smaller government. Obama has said useful things about financial reforms and has supported some infrastructure funding, but he too has lacked the courage to tell the hard truth about the ditch the country is in and how to get us out. Obama's limited comments suggest he sees the crisis much the way Washington does. That won't be good enough if he becomes President--though a deepening crisis may force him to take bolder action.

Whatever the two candidates claim to believe now, one of them is going to get walloped in January when he enters the Oval Office.

Solari - Originating a great deal more debt than anyone could carry, let alone pay back always ends in failure and bankruptcy of someone or something. So Fannie and Freddie's failure or nationalization was always in the cards - it was a matter of when.

If your goal is total centralized control, this is a great way to achieve it. Between Freddie, Fannie, Ginnie Mae, FHA, VA and the Federal Home Loan Bank Board, the federal government no longer regulates or provides credit to the residential mortgage market - it is the market.

Combined with the digitization of the mortgage credit scoring, origination and servicing process, the implications for privacy and personal freedom are simply stupefying. And the best part is that this can be described as the government "helping."

Econbrowser - In response to the largest de facto nationalization in US history, we have this example of Governor Palin's comprehension of this issue: "The fact is that Fannie Mae and Freddie Mac have gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help.". . . I would have hoped to have more comprehension from a candidate at a time when the estimate of a resulting $300 billion taxpayer liability is viewed as plausible.

Financial Times, UK - The US began to face the financial consequences of the bail-out of Fannie Mae and Freddie Mac after Congress's budget watchdog said the housing giants' operations should sit on the government's books and the cost of insuring against a US default crept higher. With the stock market tumbling, the non-partisan Congressional Budget Office said the government takeover of Fannie and Freddie meant the companies should no longer be regarded as outside the public . . . Peter Orszag, CBO director, said: "It is the CBO view that Fannie Mae and Freddie Mac should be directly incorporated into the federal budget." The Bush administration appeared to be caught by surprise. A spokeswoman for the Office of Management and Budget told the Financial Times: "We are working through this issue with Treasury and other stakeholders." The White House could take a different view on Fannie and Freddie and exclude them from its budgets. But this would be difficult because the CBO is regarded as the leading independent authority on US finances and its assessments guide spending decisions by Congress.

The two mortgage companies have between them $5,400bn in liabilities, equal to the entire publicly traded debt of the US, alongside mortgage-related assets of about equal value. These will now all be accounted for by the CBO, although public accounting rules mean that its tally of US government debt may not necessarily increase by $5,400bn.

Guardian UK - These two strange, gargantuan financial bodies could not have been born in Britain and they could not have been saved in Britain. They carried in their DNA both the old idealism of FDR's New Deal (established in 1938, Fannie Mae was a government agency for its first 30 years) and a much more modern and toxic capacity to bring the world financial system to its knees.

Without the US government's decision to take control - nationalisation in all but name - and to inject up to $100bn into each, the downturn could have slumped into depression. This rescue had to happen. . . At great cost, American taxpayers have defused a bomb whose imminent detonation might have caused intercontinental financial ruin. But all that has been gained is time. The world still needs to work out what should happen next. . .

Robert Scheer, San Fracisco Chronicle - The housing bubble was the result of the Ponzi-scheme antics of those other financial entities: commercial banks, stockbrokers and hedge funds, which were allowed in a GOP-deregulated market to get into the "swap" business. Through the rampant reselling of loans, the obligation to collect on a loan was divorced from the act of selling it in the first place, so who cared if the recipient of the loan was not at all qualified or the appraisal of the property value was inflated, as long as the paper was traded away, or insured, before the moment of foreclosure?

As with any Ponzi scheme, the perps, who include the legislators as well as the bankers who exploited the loopholes they provided, expected to bail long before the bubble burst. The role of the legislators, Republican-led but with far too many Democratic running dogs, was critical to the success of the scam.

The mortgage swaps distancing the originator of the loan from the ultimate collector were only made legal as a result of the Commodity Futures Modernization Act that former Texas Republican Sen. Phil Gramm pushed through Congress just hours before the 2000 Christmas recess. Gramm, until recently co-chair of the McCain campaign, also had co-authored the Gramm-Leach-Bliley Act that became law in 1999, with President Bill Clinton's signature. That gem, which Gramm had pushed for years with massive financial industry lobbying, destroyed the Depression-era barrier to the merger of stockbrokers, banks and insurance companies. Those two acts effectively ended significant regulation of the financial community, and no wonder we have witnessed an even more rapid and severe meltdown in housing values than during the Great Depression. . .

Amazingly, the turmoil in the housing market, which has led to the socialization of the nation's revered homeownership market in a massive expansion of the role of big government, has apparently not troubled McCain's conservative supporters.

CNN - Freddie CEO Richard Syron and Fannie CEO Daniel Mudd will no longer run the agencies, while the FHFA will assume control of the boards. Regulators took care not to foist blame on the two executives, adding that they would stick around to help with the transition.

Syron and Mudd will be replaced by two finance veterans charged with restoring the mortgage titans to health. Herb Allison, the former chairman and CEO of pension provider TIAA-CREF, will head Fannie Mae. Allison formerly served as president of Merrill Lynch.

David Moffett, who served as vice chairman and chief financial officer of U.S. Bancorp until early 2007 and then joined the Carlyle Group private-equity firm as a senior adviser, will take over Freddie Mac.

Independent, UK - The status of Freddie and Fannie was always a tad unclear but that suited all sides. Borrowers could obtain cheaper funds (the safety of the US Treasury meant investors would accept a lower interest rate) and investors had never seen, nor imagined, a default on a Freddie or Fannie bond. Take that confidence away and you would engineer a further collapse in the US property market, more defaults and more foreclosures.

And in the US, unlike here, these are "non recourse" - when you hand the house keys to the bank you can walk away from the debt. Great for foolish homebuyers - not so much for banks with burgeoning bad debts, which in turn makes them unable to lend. And that is bad news for the economy, for jobs and, in a vicious circle, for the real estate market.

The vast quantities of Fannie and Freddie bonds held in just about every life insurance and pension policy and bank balance sheet across the globe would have been effectively trashed, creating more damage to the financial system and to the global economy.


For a lame-duck administration this is a bold move. Financially and politically it is on the scale of the bail-outs for the City of New York and the Chrysler Corporation under Ronald Reagan and the vast extensions of federal power during the Franklin Roosevelt era.

Ironically, it was the last serious US housing slump that led Roosevelt to establish Fannie Mae as a government agency in 1938. It is strange that, in the home of free enterprise, the state should again have to come to the rescue. But when you're too big to fail . . .

1 Comments:

At September 16, 2008 2:30 PM, Anonymous Anonymous said...

Here's a better solution: instead of bailing out the money guys who caused this crisis, Washington should seize the assets of the INDIVIDUAL EXECUTIVES of the firms who are responsible for this mess; the people who generated the fraudulent loans in the first place. The money isn’t gone. It has just been swindled into a few private accounts.

 

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