It appears that a Fannie Mae (FNM) and Freddie Mac (FRE) “rescue” plan is finally on the verge of being passed by Congress, months after it became apparent that the two would be in need of significant capital injections. The plan, as reported by Bloomberg, calls for the U.S. Treasury to inject any amount they feel appropriate as long as the total exposure keeps the U.S. federal debt ceiling below 10.6 trillion (the current limit is 9.815 trillion). The Treasury’s investment will be in the form of equity, loans and a line of credit. In all likelihood, the current shareholders of the two GSEs will see their ownership stake dramatically reduced through rampant dilution. Nevertheless, it is now apparent that these companies will survive the current crisis and will be unable to bring about a global financial collapse. In approving the plan and raising the federal government’s debt ceiling the country has moved closer to explicitly guaranteeing the companies’ gargantuan debt load.
In looking back at the past six months, it is painfully apparent that the government, along with the GSEs and the marketplace took far too long to act. There was simply no leadership taken by any of the parties involved. The struggle for the future of Fannie and Freddie began in late 2007 and early 2008 as the companies saw their loan portfolios and the mortgage securities that they guaranteed become increasingly burdened by problematic loans. In an effort to remain well capitalized, the GSEs undertook significant capital raises.
They were however undermined when in February the government raised the limit on the number and size of the loans that both Fannie Mae and Freddie Mac were able to hold. While this is something that the GSEs had wanted for sometime, the government was mistaken in carrying out this action at the time that it did. In raising the limit on the number and the size of the loans Fannie and Freddie could hold, the government managed to allow the two companies to expand their loan portfolios at precisely the wrong time and in precisely the wrong areas of the country. The higher value loans were centered in the overheated housing markets and in all likelihood have managed to put the companies’ portfolios under tremendous amounts of stress over the last quarter.
In March, the government reduced the surplus capital requirement for the companies. It was hoped that this would allow Fannie and Freddie to better handle the pressure being put on their capital base by a weakening portfolio. In addition, the government believed that such an action would allow the two companies to expand their lending operations and help to rescue the U.S. mortgage market from near collapse. The dramatic reduction of required surplus capital made it possible for the two companies to potentially increase their portfolios by over $200 billion dollars and to expand the number of mortgages that they guaranteed by over $2 trillion. While we do not know yet, we will likely see in their next quarterly report that such an action has caused the portfolio to come under tremendous stress for the same reasons mentioned above. In a time when commercially traded banks were frantically raising capital and trying to conserve it, Fannie Mae and Freddie Mac were out throwing precious pieces of their balance sheet into the mortgage market, were it promptly vanished in a sea of losses. While they were undoubtedly fulfilling their federally funded mandate they were also likely attracted by the possibility of ever growing profits down the road as a result of an ever growing portfolio.
Had the government taken a stronger stance and limited the expansion of the portfolio and refused to reduce the surplus capital margins we would likely have avoided the calamities caused by the near failure of Fannie Mae and Freddie Mac, at least for a time. The time for the Treasury’s plan was in February when the two companies still had some shred of integrity and respectability in the investing community, now they are just another troubled institution that is on the brink.
It would appear that my suggestion on the future of Fannie Mae that I made in May has largely been proven correct. In my article I stated that while Fannie Mae and Freddie Mac would not fail their shareholders would in all likelihood be diluted significantly. The rescue plan assures this outcome, although it potentially leaves more on the table for current shareholders then I originally expected. The GSEs, as I suggested in May, still have several things going for them. Namely, that the two companies borrowing rate has been kept artificially low because of the governments near explicit guarantee of the companies’ debt. This should allow net interest margins to continue to expand well beyond that of a typical mortgage company. The income from servicing and guaranteeing mortgage securities should also continue to climb higher as investors will continue to have faith in Fannie Mae and Freddie Mac due to the renewed support of the two companies by the federal government and the belief that if the two companies cannot meet their obligations that the federal government will do so for them on their behalf.
While it is clear that the Treasury’s rescue plan should have come into place much sooner, it’s implementation will remove a significant headwind from the U.S. financial markets.
For Further Review:
Forbes Article from February
Bloomberg Article form March
Details of Rescue Plan
Disclosure: None
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