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

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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.