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.
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"The US taxpayer is now on the hook for the housing mess."
Hale,
I am not sure how this works, since the taxpayer is also on the hook for spiraling budget deficits, and all those IOUs in the Social Security Trust Fund. Plus, we are running a trade deficit and have a net negative international position.
Where does the money come from? Are you implying that sooner or later the American standard of living will be sacrificed to guarantee PBoC assets?
How is Washington going to sell this politically?
NO bail outs. Let them fail.
Mr. Stewart:
I appreciate the tutorial. After reading I come away with a synthesis view of, greed has average hardworking Americans footing the bill once again and implied is some people got very rich on a massive pyramid scheme that is showing signs of collapsing.
Every time I bought a house due diligence was done and it was somewhat frustrating during my first home purchase because of the thoroughness of the process (young, few years on the job, not much collateral, bigger down payment, FHA backing required). Now you tell me due-diligence became a neglected process.
Many say, that it is the fault of people who lost their homes that they entered into agreements they could not afford. While it is true that basic calculations can tell someone if they can afford a target purchase, I do not so easily assign blame to the “ignorant” mortgagee. It seems to me that the mortgager is more at fault for allowing bad wood into the building process. Bad wood may not self regulate but builders of structures must (look at the wood), to insure the quality of that built.
Are there no legal penalties for such lapses, or negligence in executing the duties of a builder of financial instruments? What is to prevent this from happening again once the storm subsides?
I just wonder if this is the beginning of a domino of bank failures; one that the FDIC is about as prepared for as FEMA was for Katrina. Frankly, I've buried a few valuables in the last couple of years.
I also wonder if this failure will start happening before the election? How can they keep THIS quiet? I know they wan to blame it on the Democrats if we win, but ol' McCain will get it right between the eyes if he wins as well.
Buckle your seat belts, folks. We don't have anything going to recover with from this Great Depression. Bush made sure of that anyway.
Heck you could see it coming like a train wreck.... The banks knew exactly what they were doing when they ENCOURAGED people to lie on the applications, pure stupidity and greed on their part...
Remember, the banks were in the CATBIRD seat, they had the money and they had control of the money...
And here we are 20 years after the Republican Savings and Loan Disaster..
If the FannieMae FreddieMac preferred stock holders - many of whom are regional banks - we could be looking at a bad situation.
I saw David Walker, former Comptroller General of the USA and head of the GAO, talk about America's national debt of $9.6 trillion and the total future commitments of $53 trillion, on CNN today. I was annoyed that he did not just come out and endorse Obama. How can you not do that when the Democrats preach a balanced budget and the Republicans do not even concede that deficit spending year after year after year - to preserve tax cuts for the rich while continuing to prop up the defense and oil industries - is just plain unwise and irresponsible? This is one of the reasons why this former Republican switched political parties permanently a few months ago and embraced Barack Obama.
You cannot preach fiscal responsibility and not endorse a candidate. Economics and fiscal policy are topics that are too complicated for the average American. I have a neighbor who told me that every President in recent history has been running up deficits, and I had to correct her that Bill Clinton had been running balanced budgets.
http://cnb
Is China still buying our bonds? Face it, this only temporarily delays the almost-here financial system failure and currency/monetary collapse as confidence whithers away, with ordinary taxpayers getting stuck repeatedly to cover expenses of the reckless empty-suit power & glamour guys. So instead, how about a special "Make it right with America" tax applied only to corporations that have paid no income taxes, or have moved to Bermuda, or moved all their factories to China, to cover the losses at Freddie Mac and FNMA, and this time, Joe Sixpack can keep the money that otherwise would have been pried out of his slender wallet?
Manoman, Bonddad, you're a wonderful explainer! Thanks for this blog!
When we got our last mortgage, in 2001-ish, we literally begged the bank to keep the mortgage here in our little town. We felt that if they did, when we made payments (with interest), we would be supporting our own town and the people in it. After all, the bank would be receiving regular infusions of profit from us. It was no dice, though. They sell all their mortgages, regardless of the credit standing of the clients (ours was great - we told the bank the interest rate we wanted, and we got it). Of course, the bank did make money on us, but mainly it was some huge companies and their investors - that have no vested interest in our town - that made the profits.
Maybe I'm just too old for words, but I prefer the old mortgage system. Loans are made whenever the bank feels that they'll be paid back. Period. The recent system adds too much smoke and too many mirrors to the simple process of borrowing money and paying it back.
It's for stuff like this that we need a Government that will look after the long term well being of it's citizens. The Republicans love talking bout "less government" , but every time their polices dismantle government's checks and balances, the long term outcome is usually disasters like this, then they want the same Government to bail them out. Come on guys,,u can't have it both ways....
Yes, they can, and they do. That's why they fight so hard to get in power.
Money is ALL they care about
Exactly, think Enron and Phil Gramm (who thinks we are all whiners and is McCains pick for Treasury).
When is everyone going to quit blaming everyone else and the Goverment for the mismanagement and short comings of there own lives. Every person that walks into a bank knows what kinda income they have and wether they can afford something or not . The Government Is not the only one's overspending! A large percentage of Americans are doing the same, because they can't resist the temptations of todays society (credit cards, SUV's,plastic surgery's, huge homes, etc.), alot of people are to worried about there self- image which leads the majority into the crisis we have now.
Actually this problem was created by Washington, not Wall St.
And, it has been building since at least 1971, perhaps as early as the 1950s.
Please be honest about the ideological root of your ire at these companies.
They were created to: 1) Keep mortgage money flowing. 2) Increase home ownership. Neither makes loans, and neither swindled borrowers.
The government dictates operating rules for them. Although owned by shareholders, they are constrained by Congressional charter--something few critics advertise.
Constraint #1: Housing Goals. Fannie and Freddie MUST lower the credit-worthiness standards for a chunk of loans they buy from lenders. People can object to this Congressional mandate, but it is dishonest to equate it with reckless behavior.
Constraint #2: Mortgages Only. Unlike competitors, the GSEs are allowed ONLY to buy/guarantee mortgages and package them into securities. Fannie and Freddie cannot diversify like banks and brokerage firms can; they fund mortgages--in good times and bad. Banks and brokerages have retail operations, credit cards, investment banking, etc. to diversify shareholder risk.
These constraints drive the "implicit" government guarantee. This backing makes the cost of funds to Fannie and Freddie lower than their competitors, creating the potential for a higher return. This is not bleeding-heart liberal policy; it is market reality: Shareholders demand a higher return in exchange for the higher risk of mortgages only.
Yes, shareholders should bear some risk for their bet on these firms. I say "some risk" because this privately-
More people should understand more of this story before jumping to a conclusion.
Hale, since you obviously think about this stuff more than I, do you have an opinion about what would be a reasonable way to restructure the mortgage securitization business after the bail-out phase is over (realizing that this may take years). I’m assuming that we agree that mortgage securitization is a good idea in principle.
To me, the fundamental problem is not specifically Alt-A loans, but that that far too many originating lenders let their underwriting quality control lapse -- some on purpose, some just because they were incredibly short-handed. This resulted in a huge slug of conventional loans that looked fine on paper, but that were more weakly secured than they looked (overoptimistic appraisal values, inadequately documented income or assets, tweaked credit scores, under-priced risk premiums). The GSEs certainly had nowhere near the manpower to re-examine the quality of all loan packages in detail, especially because the defects were often quite hard to detect.
So, how would one organize things to prevent a recurrence? (Not that I’m expecting another real estate bubble in what remains of my lifetime.)
FWIW, my own thoughts on the matter follow. But I’d really like to hear yours.
"prevent further losses" ???
I totally don't understand this situation, but I thought the losses were caused by people who couldn't make their mortgage payments?
I don't understand how the government taking over can stop further losses if the economy is poor and more people lose their jobs, more foreclosures will occur causing more losses.
Yes, they were "caused" by people not being able to pay their mortgage payments, BUT those people merely hopped on a mortgage train ride fueled by an absurdly cheap money policy the government (or the Federal Reserve) created. That caused a surge in real estate sales, a rise in real estate prices, AND the false assumption that prices would continue to rise.
Meanwhile, the government allowed banks to make loans to buyers on ridiculous terms based on the assumption that the train ride would never end. The real estate market is a nest of scam artists who took the leeway the government gave them and sold bad loans to a lot of people. It worked as long as real estate prices kept going up.
Eventually some delayed loan terms (adjustable rate mortgages) caught up with the buyers, many of whom never should have been given loans in the first place, and began sucking them under. It created more and more "friction" for the financial train--more houses on the market than buyers to bid up their prices, The home buyers started going into foreclosure and then the BANKs couldn't pay back the institutions who loaned them money, who bought their securitized packages of lousy mortgages. So the banks are going into a sort of foreclosure.
Now the government is coming to the rescue of the banks, but not the home mortgage borrowers.
I think they are talking about losses in confidence in the dollar and losses of investments by China in our debt. But it won't work.
"Prevent further losses" should really be "REDUCE future losses".
At least part of the problem is due to the mortgages themselves.
People got into ARM mortgages they could afford the payments on UNTIL the mortgages reset and payments went up. They didn't start to default until then. Most seem to have been enticed by the idea they'd either flip the property making a profit off the increased value or be able to refinance at a lower rate before the reset .. or that record low interest rates were here to stay, and the loan would never reset upwards.
One way the government's going to have to prevent further losses is find some way to convert those mortgages into fixed rate conventional mortgages at the original low rates, at payments the borrowers can pay and try to keep the borrowers out of default. It may, in fact, mean writing off at least some portion of the original mortgage in light of the fall of housing prices due to the crisis.
So far though, all of the proposed "remedies" have concentrated on bailing out the financial markets and not on doing whatever has to be done to keep the people who have these mortgages in their homes and out of default.
But that's where the conservatives balk. It's ok with them to bail out Wall Street con-men, but the average working stiff who's getting ready to lose his home has to take "personal responsibility".
I'm changing my name to Chrysler!
Taxpayers money will be necessary for this bailout and then maybe some (e.g. when the FDIC finally runs out of money). All these bailouts will result in the creation of more money as the funds cannot be provided by the government from income in the form of taxes (yet?). It seems unlikely now that deflation as in Japan will be America's problem. I wonder when the FED will finally step in. When even 'core' inflation reaches double digits?
Gee, on this mornings news they were saying it is a world wide slump in the economy. Can you believe it, that dastardly Bush and Cheney caused a recession in Japan, Laos and Argintina. Bush has ruined the whole world.
1) The US is backing up this mess with taxpayers' dollars.
2) Bush has cut taxes over and over, thus the backup is IOU's.
3) The financing comes from selling treasuries to foreign governments.
4) But the US has a massive and growing deficit, with no end in site, and the dollar continues to plummet in value.
Thus, is there any wonder the US isn't dragging down the global economy? All these countries fell for the same Ponzi scheme - and it all ends on the backs of US taxpayers. Looks like another flock of chickens will be coming home to roost.
Mr. Stewart, thanks again for a wonderful blog.
No, other countries themselves share the blame for investing so heavily into US Mortgage Banked Securities. They should have kept their money at home.
they lend money so the banks could issue homeloans to worthless borrowers.
the whole concept of having FNM and FRE is ridiculous!! since when is it govt's business/r
if there were no FNM and FRE to begin with.
1) mortgages would be very hard to get.
2) banks wont be able to pass on the toxic loans to GSE's
3) stringent lending standard would have to be maintained
4) if a bank failed, govt. wouldnt have to bail it out.!!
Yup. Not only have they managed to screw up the U.S. Economy, but they're dragging the rest of the world down with us.
So let me guess how this plays out from here: we overreact and slam the door shut and overregulate after the money has been stolen until the business/criminal wing waits long enough for memories to fade and then starts complaining that regulations need to be loosened, right ?
Works every time, right ?
Like this leveraging scheme wasn't obvious for what it was. When are we going to take fast money suits down off of the American pedestal ? Right after faux proud-to-be-dumb hicks in the WH, I guess.
'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.'
Presumably this will be done to benefit those investors
who 'own' Fannie and Freddie, and no other reason, hardly.
Although it will help to calm the nerves of all other investors,
maybe even some homeowners with mortgages too.
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