The Fannie/Freddie Bail-Out: The Plan and Why Now?

It's official: the US government is bailing out Fannie Mae and Freddie Mac. Over the last 24 hours there have been a lot of stories and a lot of analysis of the situation. I would encourage everyone to read as much of this as possible; this is one of the most important developments in the financial markets in the last 30 years (if not the most important).

Here is a link to Paulson's complete statement.

Let's go through some of the points in detail.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

In short, Fannie and Freddie will grow a bit and then become far more manageable from a size perspective. This is a very sound policy, if only to prevent a bail-out of mammoth proportions from having to occur again. It's important to note there is no mention of where the downsizing will end - that is, will Fannie and Freddie decrease the size of their respective portfolios for two years or ten? There is no firm answer to that. I suspect that no one really knows. Instead, the players will use a "wait and see" attitude regarding this whole mess.

Treasury has taken three additional steps to complement FHFA's decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders - senior and subordinated - and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

All this means is both institutions will issue a special type of security that will be sold only to the US Treasury. In return, the US Treasury will provide funding to keep Fannie and Freddie's net worth positive. In accounting parlance, this means both will have always have more assets then liabilities. This will prevent Fannie and Freddie from having to raise capital in the financial markets. Instead, they will simply go to the Treasury.

The implied understanding with this arrangement is the currently existing common and preferred shareholders will bear the brunt of the losses because the Treasury will have a superior claim on Fannie's and Freddie's assets. In short, common and preferred shareholders are left holding the bag at this point.

Back to the plan:

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Not only is there a preferred share program in place, the Treasury is also backstopping each agency with a secured lending facility. In other words, Fannie and Freddie can either issue equity which the Treasury will buy or get a loan from the Treasury. Either way, ample funding is available.

Finally:

Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.

So, the US Treasury will now buy agency MBS securities.
So, to review the plan, there are four parts.

1.) Shrink the size of Fannie and Freddie, largely through natural attrition of the mortgage portfolio
2.) Purchase special equity positions from Fannie and Freddie
3.) Offer a special line of credit to Fannie and Freddie
4.) Buy - on a temporary basis - agency MBS from Fannie and Freddie

Points 2 and 3 were specifically granted to the Treasury in the housing bill passed about a month and a half ago. At the time, Paulson said he had no intention of using either. I have not seen point number one mentioned at any time, but it does not surprise me. And point number 4 is merely an extension or enlargement of the current Federal Reserve lending program (one of the alphabet soups they initiated over the last year).

Why is this happening now?

There is also an interesting point mentioned in the Treasury statement: "as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free." Consider this in light of the following points from the blog, Angry Bear:

Now consider the following from MarketWatch,

"The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities.""

China alone holds $376 billion in bond holdings.

Unless I am misreading something, foreign central banks will be protected, including China's...and the America taxpayer will foot that bill.

Secretary Paulson has been busy of late reassuring foreign central banks that they will be protected.

"In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments.

In one such conversation, at the end of August, the Treasury sought to reassure the Bank of Mexico, according to a person familiar with the matter, of the soundness of agency securities held by the bank. Treasury officials have also had similar conversations with Japanese investors who are buyers and holders of agency debt."

Let me place this in perspective with the words of my friend New Deal Democrat over at Economic Populist:

6. Our new Chinese creditors have demanded their first payment. Several times in the last week, Chinese officials have stated in no unceertain terms that they would be VERY UNHAPPY if their Fannie and Freddie bonds weren't honored in full. Forget the Fed: US economic conditions are now dictated by the People's Bank of China.

The point of all this is clear. Over the last 8 years, the US has become extremely dependent on foreign financing for our way of life. Should this fall apart, we are in a world of hurt. As Angry Bear noted (same citation as above):

Yu Yongding, former advisor to China's central bank, put the matter bluntly:

`If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

Foreign central banks have been propping up the U.S. economy:

Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

The bottom line as to why this is happening is pretty clear: out creditors are getting nervous about the US's financial condition. They want to make sure they get paid. So Paulson and everybody else involved is making sure that happens.

Comments

[LuckyBlessed]

I don't know if there is much more to say at this point. I averaged $500 to a $billion in conventional and FHA and I pointed out the risk of most of these loans in 2006, particularly Bear Stearns. The COO got rid of me for her son whom I supervised. Then I watched as one company after another went under, no news coverage. I haven't had full time employment since.

Yu Yongding, former advisor to China's central bank, put the matter bluntly:

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately,....`If it is not the end of the world, it is the end of the current international financial system.''

[Charley2u]

This does not seem to be the last shoe to drop. What now happens to treasuries? What happens to the unstaunched bleeding that is the US current account, trade, and fiscal deficits.

To reduce dependence on foreign lenders the US has to rein in domestic demand. That means:

1. military spending goes, or
2. all other discretionary spending goes, or
3. massive tax increases, or
4. accelerated depreciation of the dollar - inflation which forces imports into line with exports.

Why aren't John McCain and Barack Obama being asked about this????

Why is the press, including Huffington Post perseverating on the Palin story when the implications of this virtually promises to change the entire economic landscape of this country.

Is it that difficult to connect the dots for Americans? Is this story "too big tell?"

This story will descend like a toxic cloud on us, our neighbors, our communities, and the nation, and we will not have been warned - I cannot believe this story cannot break through the media's preoccupation with a hockey mom from Alaska!!!!!

[LuckyBlessed]

See the 60 Minutes interview(on You Tube) with former GAO head David Walker, who stepped down after Bush wanted him to stop investigating Cheney. Also the movie IOUSA.

[Aaror]

(Maybe this will post this time)
So when we say the taxpayer will pay for it, I am guessing it will be added to the debt, but I have a question. The current treasury bond interest rate is 4.27% (30 year T-bill). The T-bill is generally considered to be the closest thing to a zero risk-premium bond. Given that the federal funds rate is 2%, you can extrapolate that the tive value of money portion is about 2%. The inflation rate for last month was 11%, if this extends for a year, the interest rate for bonds will have to rise to handle expected inflation, plus time value of money cost. This could raise T-bill interest rates to 12% or more. by my "back of the envelope," calculation, an extra 8% interest on 10 trillion dollars of debt is an extra 800 billion dollars a year of interest payments.
All of this is before any inflationary pressure caused by foreign interests seeing their dollar denominated assets depreciating, or any added risk premium on T-Bills for that reason. This is also before any interest rate pressure from a contracting economy and the "crowding effect," of the national debt.
My question is, if the payments on the national debt go up by $800,000,000,000, at least tripling the current payments, how will we pay for it? Or will we just borrow the money to pay the interest?

[RetireGreen]

Hale:
Excellent. You nailed it, the last paragraph sums up the cause, the catalyst can be found here:
http://www.iplanretirement.com/retirementblog/fannie-freddie-you/

The Feds decision at their last meeting, to leave rates unchanged I believe, triggered the foreign banks exodus out of Government Debt.

Their is a silver lining. After the election, the FED will begin raising rates, which will benefit retirees tremendously. Retiree income, from holding government bonds will increase, and inflation will decrease.

[themodernleader]

Historians will note that information in the latter years of the American Republic was severely limited and censored to the average citizen. The citizens voted the issues that the media and their owners displayed. The issues triggering organizational decline were hidden from public view until it was too late for remediation through the ballot box. The Fnm and Frm bailout was just such an example.

[LuckyBlessed]

It's just capitalism baby! (Oh, Communist Red China has that too, oops)

[Robert59]

Bonddad,

Why doesn't the government simply buy back all the securities at the price they were sold? Then it's a matter of unbundling them, and then liquidate. If the government wants to be in the mortgage management business they can hold the notes or sell them to banks with the stipulation they can't be resold.

It's still going to be a mess, but at least we can put banks back in the business of note ownership.

[americaforme]

Who didn't expect China to pull the plug, China wasn't a victim,the Dragon was a calculated double dealing business monguel. We lapped it up, for stuff,and things. Now the frugal American is condemed to more slavery, because of congress's enlightened despots. The executive branch would'nt have this power to throw the average american under the bus,via the Federal Reserve, if we didn't let them. Being born in the year of the Rat, its not hard to see this coming.

[sophiep]

You say that the current preferred / common shareholders will be left "holding the bag".

To use a real "Main Street" analogy -- there's a guy that owns a clothing store. He has a lot of inventory of clothes. He owes a lot of money to a bunch of different banks. His banks have recently told him that they won't continue to let him borrow so much money -- or if they do he will pay more.

His cousin Vinny comes in and says -- I'll give you all the money you need to make up any losses, I'll buy whatever clothes you need me to buy, and if you need cash to keep it all going -- I'll give you that too.

Vinny ends the conversation by saying that normally -- as a private, money lending person -- he would expect to own his cousins business. Normally, Vinny would say that his cousin no longer has any equity in his clothing business because Vinny is the one providing the money to keep it going.

But then Vinny says that because there are taxpayer funds involved -- he's still going give all the money, but he will still keep his cousin's equity in there. And -- based on Vinny propping up the business -- there's a good chance there will be profits in the future and his cousin will get a share in those.

And -- because taxpayer funds are involved -- journalists will describe this as Vinny's cousin "bearing

[HawkOnTheLeft]

People talk about moral hazard in this context.

The real icon of moral hazard in the sub-prime crisis is Anthony Mozillo of Countrywide, who took home (I think) $600m for originating several hundred billion of sub-prime and Alt-A loans and shoveling them as fast as possible into neat CDO bags for other investors to worry about. Yep, the opportunity for profit without the risk of loss.

It was the lack of regulation of mortgage underwriting regulation that gave him this opportunity. Treasury and the Fed didn't come out until September 2006 with a guidance that said "don't outsource your underwriting to someone who doesn't have the same business objectives you do."

Moral hazard here won't result from the takeover of the GSEs - it caused it.

Thanks, Bonddad!

[LuckyBlessed]

Unless you outsource the underwriting to someone you get to sign a contract saying they will repurchase bad loans and they have enough liquidity to do it. The general consensus was always it's somebody else's problem. Guess that somebody else, the pawn broker China, isn't too happy with us.

Mozillo, he was the king pen, but there were many others raking it in. And if you dared to speak about risk, bye, bye...

[January]

So Paulson is trying to buy some time. He’s hoping that if everyone just keeps on doing what we have been doing, somehow it will all work out.

The American consumer has happily been keeping the world economy developing. We have done it on unlimited credit. During that time the consumers in Asia and Europe have benefited from a favorable balance of payments. Everybody was happy...until the gamesters in the financial markets had to push the envelope until it burst. They will always do that. Only wimps refuse to gamble against impossible odds.

It is a kind of world leadership to keep the exchanges flowing. No one with any sense thought it could go on forever. It is now time to renegotiate. We need to reduce American overseas debt. That means we have to pay our way. That means we must return to a tax base where corporations and the wealthy pay a larger share.

With a little bit of luck the American electorate, even while not knowing what is in our own interest, will give us governments willing to pay our IOUs. The GOP will do everything in its power to take all the cream for itself. Even if Obama gets elected and has a Democratic congress, we cannot expect a lot by way of change. It’s still a crap shoot. But that’s better than Russian roulette.

[themodernleader]

This agreement will destroy our currency and turn us into a vassal state. What are the words in the Constitution for those who conspire to destroy our Organization? This sell-out turns America into a captive nation. Our citizens and failed government are the victims. Bondad, you have stated the problem and policy accurately.
I never dreamed in my lifetime that I would witness an Administration consistently following a suicidal economic policy for no rational reason except the continuation and consolidation of power. This betrrayal of a democratic people's trust has no historical precedent in citizen governance to the best of my knowledge. The die is cast. What else is there to be said?

[LuckyBlessed]

But power, winning is everything isn't it. Win at all costs, isn't that why McCain chose Paulin?

[Steve13133]

"existing common and preferred shareholders will bear the brunt of the losses because the Treasury will have a superior claim on Fannie's and Freddie's assets" How about the taxpayers that will foot the whole bill. It's time for the market to prevail. That means there will be losers as we let Fannie and Freddy collapse into the dustbin of bad businesses. But that isn't likely to happen as the treasury shifts the printing presses into overdrive. Hold on for hyperinflation so we can keep foriegn investors happy! Problem is, when hyperinflation hits, we wont be able to afford Chinese products anymore either. We'll be totally streched out so that we can barely afford our food and shelter. China is going to take a hit anyway, this just buys them about a year or two. Hello Global Depression.

[wldnswmmr]

Hale, isn't it becoming apparent that this is simply another step on the path to complete financial perdition? The world has, to date, allowed the United States to determine how rich it is by running its printing press and creating, out of thin air, the world's "fiat currency." The taxpayers are not going to be stuck with the cost of the GSE bailout any more than the taxpayers are actually going to pay the national debt. We're just going to keep piling the debt up and running the printing press for as long as we can. OF COURSE Fannie & Freddie were selling fraudulent MBS (mortgaged bulls___). It's what we have left to collateralize, our housing stock, and we needed to mortgage as much as we could regardless of whether the owners could pay it back. The bonus was that the world fell for it and bought this crap. Now they've figured it out. So we'll run the printing press and buy all those bad MBS securities ourselves and pay China and the rest of them for theirs to boot. Adding HUGE amounts to the national debt. The trick is to get away with the trick, the group delusion that allows us to determine how rich we are, for as long as we can. Someday, and someday soon, we will fall back to our actual, real standard of living determined by our real productivity. That won't be pretty. Paulson hopes it doesn't come before November 4, 2008.

[funkalicious]

4.) Buy - on a temporary basis - agency MBS from Fannie and Freddie

Loosely this translates to Buy More BS......haven't we just added 5.2 trillion to the deficit by monetizing these corporations??

And the list failed to include the 100 billion in Freddie Fannie bonds that Russia owns.

The dollar is toast.

[Oldbuck]

If we don't change the fundamental cause a of the failures of Freddie and Fannie bailing them out it not going to cure one damn thing. This was a well thought program which was beneficial to the mortgaged back securities business. But the Republican have a way of letting the fox guard the hen house. They let the market dictate the underwriting of these mortgages because the economy was not sound and this was a phony way of propping it up. Any time you start the trickle down theory of the Republicans you are going to have this problem. They though this was a winning position but they forgot one thing if there is no economy no one has the money to pay for these damn mortgages.
UN SOUND UNDERWRITING IS THE CAUSE OF THIS.