Fannie and Freddie Bail-Out: How We Got Here and The Plan To Get Us Out

The Housing Crisis has claimed its two largest victims: Freddie Mac and Fannie Mae. Plans have been announced to place these institutions into conservatorship (I'll get to that in a minute). What follows is

1.) A brief explanation of what Fannie and Freddie do and why they are so important

2.) Why they are in trouble, and

3.) And overview of the government's plan.

This will be a long article, so get ready to sit awhile.

A Brief Explanation of Fannie and Freddie

So, what do these two institutions do? Why are they so important?

Let me explain that by comparing the mortgage business of 100 years ago to the mortgage business of today. 100 years ago, a borrower would go to a bank and get a home loan. However, the bank would own the loan for the duration of the loan - that is, the bank that made the original loan would be the bank that sent out monthly statements and collected mortgage payments until the loan was paid off.

Let's compare that to the mortgage business of today. Today a borrower gets a loan from a lender. Once the loan closes, the lender sells the loan to a larger financial institution. Sometimes this is Fannie and Freddie, sometimes it's some other large financial institution (think Citigroup, JP Morgan or another large, money center bank). Fannie and Freddie stood atop the financial pyramid of buying, selling and pooling mortgages. They issue the largest amount of securitzed product. They touch about 70% of all US mortgages. Both institutions have (until now) an implied governmental guarantee. That gave both institutions an incredible advantage in the market by allowing them to borrow at slightly cheaper rates then their competitors. This is how they attained top dog status in the financial world.

As mortgages moves up the food chain to larger and larger institutions these institutions "securitize" the loans, which

is a structured finance process, which involves pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors. The name "securitization" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities.

The "pooling" occurs with mortgages that have similar characteristics. For example, Fannie, Freddie or one of the larger financial institutions will take $100 million dollars of 30 year 6% mortgages that are from a geographically diverse area and "carve them up." This means they create a group of different bonds that pay principle and interest at different times to attract different types of investors. The securitization process has been around for about 30 years or so and has been very successful

Let's review a bit. The primary difference between the old and new mortgage business is the number of financial players involved and what is eventually down with an individual loan. It use to be that a lender would hold a loan for the duration of the mortgage. Now, multiple financial players are involved and the loan is securitized, or made part of a larger pool of mortgages and then cut up into different cash flows or bonds.

What Went Wrong

There are two inter-related problems that led to the current mess. Remember the difference in primary way of doing business 100 years ago and today? It use to be that one person/institution handled the loan. That encouraged the institution to perform in-depth due diligence - which is a fancy way of saying making sure the borrower will pay back the loan. Now multiple institutions touch the loan. That means the incentive to perform due diligence is far lower (or non-existent). There is also the issue of securitization and the effect it has had on risk management. Financial people had come to think that securitzation insulated loans from risk. Put another way, people thought that the process of securitization so spread out the risk among mortgages with similar characteristics and different institutions who purchased the structured product that the possibility of losses were non-existent.

Nothing could be further from the truth. All of these bonds that have been securitized have been created from weaker and weaker collateral. As a result, the actual value of these bonds has continually deteriorated as the mortgage delinquency rate has increased. As a result, we continually hear about various financial players "writing down" the value of a loan or an asset. This means the owner of a bond is saying, "this bond is no longer worth $100, but instead is worth $90 because the collateral backing the loan is so bad."

Here's a metaphor to explain. Suppose you are building a series of houses. The first house is built from solid, good quality wood. But as you progress you continually use lower and lower quality wood for the frame. Eventually the wood used for the frame comes from termite infested trees. Houses made from this wood simply aren't going to stand the test of time.

An Overview of the Government's Plan

Let's start with a bit of history. This story has been brewing for a bit - the issue of governmental control/bail-out of Fannie and Freddie. It officially started with housing bill passed about a month ago which contained the following provisions:

The plan we announced will strengthen our financial system as we weather this housing correction and establish a new world class regulator for the GSEs; it has three parts.

First, as a liquidity backstop, the plan includes an 18-month temporary increase in Treasury's existing authority to make credit available for the GSEs. Given the difficulty in determining the appropriate size of the credit line we are not proposing a particular dollar amount. Flexibility is the best means of increasing market confidence in the GSEs, and also the best means of minimizing taxpayer risk.

Second, to ensure the GSEs have access to sufficient capital to continue to fulfill their mission, the plan gives Treasury an 18-month temporary authority to purchase - only if necessary - equity in either of the two GSEs.

Treasury Secretary Paulson assured us, however:

Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop. If either of these authorities is used, it would be done so only at Treasury's discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE

Many people called "foul" on the last statement (of which I was one). There was no reason for the Treasury to ask for such broad authority unless it was needed. And needed this plan obviously was.

According to the Wall Street Journal:

The plan is expected to involve putting the two companies into the conservatorship of their regulator, the Federal Housing Finance Agency, said several people familiar with the matter. That would mean the government would take the reins of the companies, at least temporarily.

It is also expected to involve the government injecting capital into Fannie and Freddie. That could happen gradually on a quarter-by-quarter basis, rather than in a single move, one person familiar with the matter said.

In addition, Treasury's plan includes a top-level management shakeup at both companies, according to people familiar with the plans. Daniel H. Mudd, chief executive of Fannie Mae, and Richard Syron, his counterpart at Freddie Mac, are expected to step down from their posts eventually.

A conservatorship occurs when the people in charge are attempting to "conserve" the assets involved. Compare this to a liquidation where the people in charge are selling assets to pay off creditors. The point with the current plan is to keep things running and to prevent further losses. The New York Times described it thusly:

A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.

Also note there will be a continual injection of cash into these organizations. Considering these organizations own or guarantee $5 trillion in mortgages, we could be in for a bumpy ride.

As for firing those in charge, it's about time. These idiots got the companies into the mess; there is no need to keep them around.

Here's the short version: The US taxpayer is now on the hook for the housing mess.

Comments

[Jim--C]

in china they would be executed

[researcher]

"As for firing those in charge, it's about time. These idiots got the companies into the mess; there is no need to keep them around."

you like most every body misses the point.

capitalism must fail it is about profits not people.

reagan put capitalism on steroids and hasten its failure


capitalism failing is a good thing universal law demands that it fails

universal law over rides man's ignorance

even the progressives dont understand the failure of capitalism

we now have corp socialism and individual capitalism

the end is near vote for mc cain and hasten this end ie with dr phil G as economic advisor

like pulling a band aid off quick

with communism man exploits man with capitalism it is the other way around

americans will stick with capitalism until total economic decline

in fact americans want more capitalism

that is the power of paradigm paralysis

[abu talal]

I would agree that there exists an air of complacency amongst senior figures in the largest organizations in the states - meaning that they are less cautious when assessing the risk of lending / borrowing / merging, as there is an over-riding assumption that the government will always bail them out if things take a turn for the worse.

At the same time, however, when we're dealing with companies of this size, there's just no way you can let them go under, so what other options were there?

Abu

[JBS]

Fannie & Freddie:
1) This is the clearest explanation of the problem and proposed solution I've seen.
2) It's clear as mud.

Looks like the ones who screwed us over are getting paid off, and the ones who got screwed are going to be stuck with the bill ... and no one knows yet how big that bill is going to be.

[Aaror]

not to change the subject but...
Right now the interest paid by the federal government on bonds is 4.27 percent (30 year T-bills). If inflation is 11%, granted, that is just for one month, but if it continues at that rate... won't interest rates rise? And if the US dollar starts to look like a bad investment, won't that raise the interest rate too? The reason I ask is that according to my back of the envelope calculations, every 1% raise in the 10 trillion dollar national debt is an extra 100 billion dollars a year in interest. If inflation rates stay at 10% ish, expect the minimum T-bill (at 0 risk premium) to be 12%. That means 800 billion dollars a year more in interest, even before any risk premium from the dollar declining in value against other currencies, or foreign worries about our ability to pay. Also, our debt is pretty big, we are eating up available capital, and making it harder to find money, which drives up interest rates.
um, I lost track of my point, but anyway, is an extra 800 billion dollars a year going to be hard for the federal government to come up with, or will we just borrow it?

[bugdog]

The entire banking industry should be nationalized and a new government lender created. Lending for profit should be banned.

[iambusto]

go live in a cave please. where would you get the capital for lending if you were not making any profit !!

[nezumi]

Just that I got used to 'trillion'... Can anyopne tell me what comes after that? Brazilion?

:-)

[Aaror]

quadrillion

[LeftCoaster64]

And yet the Party that has ruled the roost for 8 years and brought us one financial/political disaster after another keeps getting voted in by large numbers of voters. We truly get the government that we deserve.

[RossalGondamer]

You failed to mention a second HUGE problem within your housing as securitization metaphor – the process of note severance from mortgage payment.

What actual good is passed-on expectation of payment, if one doesn’t also assume the title to a car or the deed to a home?

If the government is going to assume the last position in this cunning chain of fools, they must ‘trace back’ and then ‘take over’ the actual note without any further compensation to actual note holding institutions – period!

[Synoia]

There is an electronic system to "pass" ownership of notes. I believe its acronym is MIERS. There were court cases by county recorders offices about the validity of this electronic transfer, and I believe the recorders lost.

[Robert59]

You bring up an excellent point.

Fannie and Freddie sold securities to investors promising them a certain rate of return. They are unable to pay the purchasers of the securities the interest owed. They also lack the money to buy back all those securities.

When the taxpayer foots the bill what happens to the securities? Do they become property of Fannie and Freddie again or will we go the RTC and see huge liquidation sales?

What is this bailout really going to cost the taxpayer?

Is Uncle Sam going to be the nation's largest homeowner owning half of all mortgages?

[dadw5boys]

You forgot to mention that when banks control mortages they also controlled who could buy a home and where they could buy.

Sallie Mae got rid of the discrimination in home loans !!!!!!

Sallie Mae was so successful Freddie Mac was needed.

Now banks want control again and they got the laws passed needed to destory Fannie Mae and Freddie Mac so they get control cheap.

JUST SAY NO TO THE BANKS !!!!

[Synoia]

Mae be, Mae be not. Sallie Mae if for student loans, Fanny Mae is for mortgages.

[iambusto]

lets make a law that anyone without a credit score of at least 700 doesnt get qualified for any home loan at any rate. stop giving loans to losers !!

[Waubay]

Wish I had some(any) artistic talent. Just thought of the best cartoon for this. Little league baseball player standing in the outfield his shirt says 'Taxpayers.' He is holding his glove up yelling, 'I got it!' as a 2 story tall, extremely sharp butcher knife labeled 'Fannie Mae, Freddie Mac' falls toward him.

[Thermodynamics]

Question about GNMA mortgages:

What happens when people negotiate with their local bank to foreclose on a house? How does the local bank have any authority? Sometimes owners simply want out. Currently what I hear about in Florida is banks taking back houses with no bankruptcy proceedings.

In the 80s and 90s I used to buy Ginny Mae pools instead of CDs. For $80,000 you would get a small part of perhaps 50 different mortgages. You got an interest check every month and you got principal back as each loan was paid off or refinanced. So I understand the consolidation part about securitization. The loans are held in a group, several steps up the food chain from the original bank.

[Thermodynamics]

Clarification about the $5 trillion figure: Hopefully Fannie Mae and Freddy Mac will only get stuck with problems on about 20% or less of the mortgages they hold, so maybe the bailout will be less than $1 trillion.

[Thermodynamics]

To provide some perspective on that $5 trillion that Mr. Stewart is talking is talking about:

It is almost equal to the debt part of the national debt, $5.7 trillion.
The total value of all US residential real estate is now about $22 trillion.

Real estate was only $11 trillion around year 2000 but we have had new construction and price appreciation, as well as inflation, bumping that figure up.

Bush has added about $500 billion (half a trillion) to the national debt every year, so it is around $5.7 trillion. (low value)
The high value is $9.7 trillion. That is, it is $9.7 T but we have about $4 T in assets.

Statements about the size of the national debt are tricky because you can describe it with or without subtracting positive assets in social security and highway funds, etc.

Clinton did have balanced budgets and he left office with the debt down at a reasonable level.
http://archives.cnn.com/2000/ALLPOLITICS/stories/09/27/clinton.surplus/
http://en.wikipedia.org/wiki/United_States_public_debt

[Kristen16]

Please tell me why no where in this article did the author state the three real reasons behind the mortgage mess: Personal Responsibility is Dead. Blame Someone or Something Else. "Government" will pay for the character mistakes of others.

[dadw5boys]

1. All Property Appraisers who over valued property so the loans looked good on paper.
Pull their license and they are not allowed to work in Realestate again ever.
2. Same with Realestate Agents who sold the over valued homes.
Out of Realestate for good.
3. Employ the RICO ACT against Country Wide and others who made these overvalued loans nore than 3 times. It is Fraud to do it once. It is Organized Crime to do it 3 times or more.
4. Jail them!
5. Auction off some of the homes but put them on the internet for everyone to see not thru Real Estate Agents.
6. Hire Unemployed people to fix them up for sale. Just a few at a time.
7. Go after the Commerical Property fast that is in trouble before they let it run down to far.
8. Let the SBA put new businesses in that Commerical Property !!!!!!!