Fannie Mae and Freddie Mac in Layman's Terms

Everyone else is writing about Fannie Mae and Freddie Mac so I figured I would as well. The two companies play a central, indeed, the central role in the mortgage marketplace. They don't make mortgages. They buy mortgages from originating banks and repackage them as bonds or keep them on their own balance sheets. The ones they package and sell are guaranteed by FNM or FRE for a fee. Between the two functions the companies touch over $5 trillion in mortgages. They do this with a far skinnier equity base than any other financial institution. Since they were always considered too big to fail and would be bailed out by the government in a time of trouble they have been able to borrow at lower interest rates than others.

Well, they got in trouble and the government is bailing them out. To oversimplify it, the companies have too little capital to handle the growing number of troubled mortgages they either own or guarantee. Without getting into details, the mortgages they are involved with are not sub prime, and are of generally very good quality. But in tough times even good loans go bad. If you take just the mortgages they own you come to a total of $1.7 trillion supported by core capital of about $70 billion. That is a leverage ratio of 24 to 1. Throw in the guaranteed stuff and you balloon to 68 to 1. You can have a very good book of mortgages with a very low default rate and still be out of business quickly with that leverage. It's lunacy.

The Treasury Secretary announced Sunday night that the companies can borrow from the NY Federal Reserve bank. FNM and FRE have access to the "discount window." They will pledge collateral for the loans. Secretary Paulson also said the government will pursue increasing the existing modest credit line the companies enjoy and will consider an equity investment. I figure the companies will try to raise capital themselves because if the government comes in with equity capital I hope it would be so dilutive as to ruin the existing common.

My guess is that this move buys time. The markets should settle down. A key indicator will be FRE's auction of three and six month paper early Monday morning. It should go off easily, but if it doesn't that would be a sign of big trouble. FRE's three month paper went out at 2.43% late Friday.

There are as many estimates as there are news articles this weekend as to what the level of losses might be as the housing market plays itself out. I have read everywhere from $20-30 billion to $100 billion. $20-30 billion the companies can handle. $100 billion needs a slug of capital, but the truth is no one really knows. I will mention that in the midst of Friday's chaotic marketplace, Smith Barney recommended buying both stocks. And, the Savings and Loan debacle of the late 1980's and early 1990's cost the government more than $100 billion. Not to minimize anything but there are solutions and "This too shall pass."

Comments

[vmonter]

De-leveraging ... in a debt society, good times!

[Henry]

Just listened to Cox of the SEC in testimony in front of the Senate state that today an emergency order from the SEC halting "naked shorts" of Fannie and Freddie at primary dealers! Wow, and here I thought that "naked shorts" were illegal already. This is a scummy set of conduct that Cox is the law-enforcer for... and it appears that he's been asleep to the detriment of those who abide by the law. (what a unique position)

[PublicAdvocate]

The potential bail outs of Freddie Mac and Fannie Mae like Bear/Stears form a policy of Corporate Socialism. Rewarding coruption, stupidity, mismanagement and lack of sound business acumen with forgiveness at taxpayer expense creates accountability problems for the future. CEO's from these companies flee with 10's of millions in salaries,bonuses and golden parachutes and admit no wrong doing.
Why should future generations of Americans too young to vote be burdened with paying for the sins and indiscretions and pure greed of today's speculators and corporate fat cats?
There is no compelling reason in the name of Justice or Capitalism to bail out these firms. Those who are in business to make money and endure risk have made billions but now must pay the cost if their practices are slip shod, stupid and sloppy. Our economy will survive and good businesses will survive and improve if a message of consequences and accountability is made. If bail outs continue to become the practice in the American business model, we can expect higher taxes, lower standards, more corruption and a continually falling dollar and economy as investors lose confidence in the integrity of our businesses and economy.

[Robert59]

Sure it will pass; everything does. But at what cost?

Fannie Mae and Freddie Mac don't have the money to pay for the defaults on CMOs and CDOs that are comprised of prime mortgages, not subprime. People with good credit histories and documentation are not making their house payments.

Remember, we just hit the first wave of the resets. Next year we get the tsunami. To minimize the seriousness of this makes you sound like Gramm.

[booker52]

Wrong, Freddy MAC, lair loans, this from Chris Dodd. And now alot of good people who had their money in this bank are losing their money if they had more then $100,000 and are trying to pull it out. It's sad as our own President refused to stop these loans. Not to mean they wrote the loans, but to say they backed them. Same thing. Alot of people hurt and it didn't have to happen. My question, who said it was ok to start with these type of loans to begin with???? I say the government should go back and put these folks in jail. But that's just me. when was it ever ok not to have funds when buying a house??? When did this ever change??? And when did our own government decide it was ok to print worthless money??

[Novista]

I wonder how HankyPanky and The Barnacle would have handled the 'tulip bubble'?

[The Hedonistic Pleasureseeker]

NEWS FLASH: "The Government" = YOU. Your money. Your children's money. Your grandchildren's money.

That said, I do believe all this talk of bailouts is simply buying time. When push comes to shove, we don't have the capital to do it. The Fed would need to pull all the money out of it's azz, and the hyperinflation from it would probably go global.

They might do it anyway. Because God forbid rich people lose any money, right? Only the little people lose money when they speculate, right?

[ATLiberal]

Everyone will be affected if Fannie and Freddie are allowed to fail. Don't kid yourself. In this case, there is no choice but to bail them out.

Citibank can fail. Chase can fail. Fannie and Freddie CANNOT be allowed to fail.

[The Hedonistic Pleasureseeker]

We'll all be affected, regardless of which way they turn. Their backs are up against a wall.

There is simply no way to "save" a fiat money fueled hybrid ENRON/Ponzi scheme once it spins out of control.

Visualize hyperinflation: Argentina. Zimbabwe. The U.S.A.

[crom]

Bankrupt - A person, firm, or corporation that has been declared insolvent.
Bankruptcy - The condition of being unable to pay debts.
Recent Ufo Report: Unapproachable Financial Obligation.

[WIpatriot]

Of course the move buys time, that's what's important until fall.

[ilovemydoggy]

What a nightmare. WHERE were the regulators? They saw what was happening. They should be ashamed. Everyone was making money, so nobody cared. What a disgrace. It's a good lesson for all of us. The government cannot protect you.
FORECLOSURES: You can get a list of major bank databases to foreclosure properties here: http://www.nancys-kids.com/reo.htm

[ATLiberal]

You are confused. Fannie and Freddie were not the source of the sub-prime money. They primarily provide money for prime mortgages. Good credit, assets, etc. More sophisticated and credit worthy borrowers.

The point is, even good mortgages can go bad when the economy tanks.

[Henry]

Regulators, after all, are political appointees. The FED, the FDIC, the Treasury. I remember that Danny Wall the head of the FSLIC (now gone by the wayside) the entity that regulated the savings and loans, was an architect! Imagine that , an architect as the regulator of savings and loans. Any doubts about the supply-side baloney of that era?
Cox of the SEC is by far the worst. Chief of police belongs to mob!

[JustObserving]

"I have read everywhere from $20-30 billion to $100 billion. $20-30 billion the companies can handle"

According to the Federal Reserve Flow of Funds Report, $10.5 trillion in mortgage debt is outstanding as of Dec '07. The total US housing market is worth around $22 - 24 trillion

If housing falls by 10%, we need a trillion or two. Given that oil prices are sky high, housing may fall 20%, we are looking at two to four trillion in losses that will have to shared by mortgage holders and consumers.

$100 billion is just a cakewalk compared to the trillions we will need.