Thursday, January 28, 2010

Fannie Mae and Freddie Mac Are Dead. What's Next? (FNM; FRE)

I've been asked why I take such an interest in the formerly Government Sponsered Entities.
The quick answer is "They're so damn big".

With balance sheets in the trillions of dollars, with bailouts in the hundreds of billions they are major players in the financial system.

Additionally they are conduits of Federal Reserve policy and have been since at least 1998 when Alan Greenspan used them to supply liquidity to the markets during the Russian default and subsequent failure of Long Term Capital Management.

With the purchase of $1.25 Trillion of Mortgage Backed Securities Chairman Bernanke took a page from the (former) Maestro's playbook.

Oh, and finally, if you understand this stuff you can [maybe -ed] make a buck or two.

Here's a threefer on the possible endgames for Fannie and Freddie. First up, the headline story from The Motley Fool:

"This committee will be recommending abolishing Fannie Mae and Freddie Mac in their current form and coming up with a whole new system of housing finance; that's the approach, rather than the piecemeal one." -- Rep. Barney Frank, Jan. 22, 2010.

What if Frank isn't just talking out of his rear, and Fannie Mae (NYSE: FNM) and Freddie Mac are really on a path to being put out of their misery? What would happen?

Your guess is as good as mine. Frank offered exactly zero details. Logically, major overhaul of Fannie and Freddie would either be:

  • A complete eradication of their roles, ending government-backed mortgage securities and loan insurance.
  • A continuation of their current roles, but only after being brought 100% onto the government's books.

Here's a rundown of each possibility.

1. Complete eradication
To the dismay of Randians everywhere, this possibility really seems like a dream. The odds of completely ending Fannie and Freddie's roles in the housing market are about the same as completely ending Social Security.

Why? Because despite the glaring flaws, the fact is there's essentially no functioning mortgage market outside of government-backed issuance. This table gives an idea just how reliant the market is on the two:


Share of First Mortgages Outstanding

Fannie Mae


Freddie Mac


Banks and Thrifts




Private Label Securities


Source: Freddie Mac.

And that's just the market share of outstanding mortgages. The market share of current mortgage issuance is even more lopsided. Fannie and Freddie combined currently make up about 70% of new mortgage issuance, with the FHA taking up close to 20%, for a total of around 90% reliance on these three government-backed vehicles.

Why such reliance? The best explanation is that large banks -- like Citigroup (NYSE: C), Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), and Wells Fargo (NYSE: WFC) -- don't have the appetite to lend directly to homeowners after being sufficiently wrecked by housing over the past three years. Also, with the yield curve the way it is, it makes sense for banks with a long-term outlook (I'd like to believe they exist) to invest in short-term Treasury securities instead of longer-term assets like mortgages. Wells Fargo recently admitted it's doing just that.

Second, the market for private securities (like CDOs) packaged by banks like Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) is virtually extinct compared with prior years, because investors now know how dangerous they can be.

At any rate, know this: If private banks were the only issuers of mortgage funding, the cost (interest rate) would blow up in a big way. To compensate, housing prices would get nuked. For example, a 30-year fixed mortgage at 5% with a $1,500 monthly payment will finance around $275,000 worth of house. The same $1,500 mortgage at 9% will only finance about $185,000.

Few politicians want to explain to their constituents why annihilating home values is worth it -- that's why there's very little chance that Fannie and Freddie's roles will actually be eradicated.

2. Continued roles, fully owned by Uncle Sam
The most likely "new system of housing finance" Frank wants is a continuation of the government-backed mortgage market, but only after Fannie and Freddie's assets and liabilities are brought entirely onto the government's books....MORE

And from American Banker via Structured Finance News:

FASB Rule Complicates GSEs' Future

Long criticized for their excessive leverage, the balance sheets at Fannie Mae and Freddie Mac will explode this quarter as they account for mortgage loans worth trillions.

The government-sponsored enterprises are being hit hard by a rule released last summer by the Financial Accounting Standards Board (FASB) requiring companies to bring securitizations onto their balance sheets.

For Fannie, that means bringing $2.8 trillion of mortgage loans onto its books; it had $890.3 billion of assets at Sept. 30. Freddie held $866.6 billion of assets at Sept. 30 and plans to transfer $1.8 trillion of mortgage loans to comply with the FASB rule.

Fannie and Freddie are unlikely to raise more capital to account for their expanded balance sheets since the Treasury Department has committed itself to infuse as much as is necessary into the GSEs to keep their net worth positive. But with the accounting changes potentially tripling or quadrupling Fannie's and Freddie's balance sheets, important questions arise about how they will emerge from conservatorship.

"Do you think the federal government can move to a post-conservatorship world with Fannie and Freddie with those kinds of balance sheets?" asked Joe Murin, the managing director of the Collingwood Group and a former chief executive of Ginnie Mae. "It's a big deal for us as taxpayers to look at the leverage here. It almost guarantees the federal government is going to be involved in this for many years."

Reckoning with the future of Fannie and Freddie is largely seen as a task for another day. The more immediate question is whether the FASB rule will send Fannie and Freddie into negative net worth and back to the Treasury Department for funding.

In a controversial Christmas Eve announcement, the Treasury effectively lifted any cap on how much Fannie and Freddie could borrow from their government credit lines.

In its third-quarter report, Freddie acknowledged the accounting change could "have a significant negative impact on our net worth and could result in additional draws" from the Treasury. Fannie said the change "will affect our net worth," but its report did not address whether it would require further borrowing from the Treasury.

Through the third quarter, Fannie had borrowed $60 billion from the Treasury and Freddie had tapped it for $51 billion. Analysts said it is impossible to guess how much more the GSEs may need to borrow.

"There certainly will be some impact on implementation," said Brian Harris, an analyst at Moody's Investors Service. "If you want to quantify it, we can't do that."

But it is almost certain that regulators will not require the companies to raise additional capital privately.

The Federal Housing Finance Agency (FHFA), which acts as the conservator for Fannie and Freddie, effectively abandoned minimum capital rules after the companies were seized by the government in September 2008.

Fannie said it was $91.7 billion below its minimum capital level by the end of the third quarter, and Freddie said it was $43.8 billion short....MORE

Finally from ZeroHedge:

Observations On The Ongoing $1.5 Trillion GSE Wealth Transfer

John Hussman shares an interesting perspective on yet another from of intergenerational wealth transfer (aka theft), this time involving the US (and by implication its taxpayers), its increasingly unmanageable debt load, and the resultant preservation of wealth of lenders to the nationalized GSE complex, which is massively underwater but will never be forced to be impaired on its holdings, for as long as the current Fed leadership is in place, and the chimera of "change" continues being just that. The kicker - Congress has no way whatsoever to prevent this theft from happening. Once again, America's entire legislative apparatus has been bypassed in order to bail out the reckless lenders who inflated this whole credit bubble in the first place.

How to spend $1.5 trillion without Congressional approval

Step 1: Federal Reserve purchases $1.5 trillion in Fannie Mae and Freddie Mac securities, creating $1.5 trillion of monetary base to pay for these purchases.

Step 2: U.S. Treasury quietly announces unlimited support for Fannie Mae and Freddie Mac on December 24, 2009, exploiting a loophole in a 2008 law that was originally written to insure a maximum of $300 billion in total mortgage principal (not losses, but principal).

Step 3: Over the next several quarters, the U.S. Treasury issues $1.5 trillion in new Treasury debt to the public, taking in the $1.5 trillion in base money created by the Fed in Step 1.

Step 4: U.S. Treasury hands that $1.5 trillion in proceeds from the new debt issuance to Fannie Mae and Freddie Mac.

Step 5: Fannie Mae and Freddie Mac use the proceeds to redeem the $1.5 trillion in mortgage securities held by the Fed, thus reversing the Fed's transactions in Step 1, without the need for any other "unwinding" transactions (watch). The base money created by the Fed comes back to the Fed, and the mortgage securities purchased by the Fed disappear, by burdening the American public with a new, equivalent obligation in the form of U.S. government debt.

Outcome: The Federal Reserve closes its positions in Fannie Mae and Freddie Mac securities, the quantity of outstanding Fannie Mae and Freddie Mac liabilities declines by $1.5 trillion, thus allowing their remaining assets repay the remaining liabilities without a $1.5 trillion hole of insolvency, and the outstanding quantity of U.S. Treasury debt expands by $1.5 trillion in order to protect the lenders, while ordinary Americans continue to lose their homes and jobs.

Throughout this crisis, the ultimate objective of Bernanke and Geithner has consistently been to protect the bondholders. This objective will not change unless the leadership changes.

While Obama's "War on Wall Street" is progressing with no impact, and will likely stimulate the bankers to merely find new loopholes to extract wealth, the one aspect of financial reform that the Administration should be focusing on, the shadow nationalized balance sheet, that of Fannie and Freddie, keeps getting absolutely no focus....MORE