U.S. Treasury Secretary Henry Paulson has announced a "bailout" plan for the country's two biggest mortgage firms, Fannie Mae and Freddie Mac. Details remain sketchy, but assuming it does not end in unmitigated disaster, this bailout could alter how the American economy is run. Fannie Mae and Freddie Mac are the colloquial names for the Federal National Mortgage Association and Federal Home Loan Mortgage Corp. Their mission is simple: translate preferential access to capital into more accessible funding for mortgage seekers. Fannie Mae was formed in 1938 as a government agency as part of an effort to mitigate the Great Depression by boosting the housing market. Fannie Mae was formally privatized, and had Freddie Mac hived off from it, in 1968 with the intention of injecting more competition into the market. Turns out things did not quite end up as intended.
Critics charge — with no small amount of evidence — that the "twins" are inefficient, bloated corporations that not only do not meet their mandate, but actually have exacerbated the current problems in the housing market. The run-down goes something like this: The twins have a financial exemption built into their charters allowing them to sell mortgage-backed securities — the bread and butter of their profitability — with only half as much cash in reserve as is required of other financial institutions. However, only a very small portion of the margin this generates is passed along to other participants in the mortgage market, which means that homebuyers only receive a slightly more favorable mortgage. The rest of the margin is absorbed by the twins' operating costs, executive perks and investor dividends. Many charge that the twins use their margin as a sort of slush fund that has encouraged sloppy accounting and outright corruption. Yet the small bit that is passed on to others is sufficient to undercut enough competitors to make Fannie Mae and Freddie Mac monster players in the mortgage industry. As of 2005 the twins held roughly 41 percent of the mortgage securities market — and that was before the recent unpleasantness in the housing market caused by the subprime crisis. Thus, a belief has developed that even though the U.S. government offers no explicit guarantees to the twins, the government cannot and will not allow them to fail for fear of upending the entire housing market. The government has few options for stabilizing home prices without upsetting the country's entire financial architecture, yet so long as home equity is the largest concentration of U.S. wealth (Americans only rarely save money, but most do purchase homes), the government has no choice but to take what steps it can. The problem (well, one of them) is that the only institutions that can assist on a scale that would make a difference are none other than Fannie Mae and Freddie Mac. After all, the twins already control a huge portion of the market and are de facto government institutions. As the subprime crisis developed, investors of all stripes began reassessing just how much the mortgages they held were worth, with subprime assets obviously being hit critically hard. Many of these assets found themselves up for sale as private investors sought to limit their exposure to low-quality securities and add cash to their balance sheets. The goal was simple: reduce exposure and maximize security (and as the conventional wisdom went, it does not get much less secure than holding subprime assets in a falling market, or more secure than cold hard cash). Cash was also handy in guarding against future asset write downs as the subprime crisis triggered a broader re-evaluation of risk in sectors wholly unrelated to housing. All these mortgage securities being put up for sale (often at less than their face value) forced their value down further. To help avert these write downs being carried over to prices across the entire housing market, the government allowed — even encouraged — the twins to use their implicit government guarantees to take on more, larger and riskier mortgages. Until this point the twins only dabbled in subprime — now they positively gorged upon it. Consequently, in only two years the twins' grip on the mortgage market strengthened to the point where they either held or guaranteed fully half of the total market. Inefficient, corrupt, flawed or not, the twins have succeeded — so far — in stabilizing the American housing market. But in doing so they have truly become "too big to fail" by any measure.
The problem now is that the twins' balance sheets are just as, if not more, unbalanced as the banks' were at the dawn of the subprime crisis. Not only have the twins shouldered most of the burden that used to be spread out among the entire market, but the problem itself has certainly deepened. We are not just talking subprime here: As housing prices fall, homeowners lose equity and more and more "safe" mortgages potentially can fall into the danger zone. Mortgage delinquency rates are already at the highest in 29 years (and rising), and the twins now bear the brunt of the exposure. So the twins need to achieve what the broader banking sector has done: reduce risk and raise capital. But the twins' semi-state status prevents them from doing this via all of the normal means:
- They were recently allowed/encouraged to purchase much of the mortgage debt, so they cannot simply dump it on the market to raise cash and reduce risk. They must continue to hold the debt even as its value leeches away, compounding their financial hardship.
- They cannot simply issue shares. Since they are semi-government firms, potential investors realize that the interests of investors are not their priority. So while those with spare cash — the Arab sovereign wealth funds come to mind — might be ecstatic to come to the aid of JP Morgan Chase, the twins generate no enthusiasm whatsoever. Unsurprisingly, the twins' stock value has dropped by two-thirds in the past month, and on July 11 more than half of their total outstanding stock changed hands.
- Bond sales raise some possibilities, and the twins' implied government backing does give both firms an AAA credit rating. But even here the market thinks otherwise, and some categories of the twins' debt are trading on the market at three credit categories lower (A3) than they are formally rated.
So while the twins have already managed to raise $20 billion to rationalize their books, in the $12 trillion American mortgage market that a very small drop in a very large bucket. Ergo, the government is stepping in with an assistance package. As part of the U.S. Federal Reserve's efforts to alleviate the worst of the subprime fallout, U.S. banks temporarily have access to loans from the Fed at preferential rates. Those same loans are now available to the twins. Also, the Treasury Department is petitioning Congress for permission to purchase shares in Fannie Mae and Freddie Mac should the circumstances require it. The first step is in reality nothing particularly drastic; the second could result in the formalization of the twins' informal status as state companies. Such a step would protect the housing market in the short term, but would only come at the cost of further concentrating the problem in the twins' hands. (Who can compete with a pair of firms who enjoy the government's express financial guarantee?) A market limited to two major players — and inefficient players at that — is one that is at near-constant risk of collapse. The only way the government could ensure that mortgages remained available and affordable would be to de facto run the system itself, with all the costs to the taxpayer that entails.
But there could
be a catch to this plan. When Paulson announced what is being referred to in the media as the "bailout" plan, he closed by noting that the plan would give "the Federal Reserve a consultative role in the new GSE [government sponsored enterprise] regulator's process for setting capital requirements and other prudential standards." To date, more information has not been released as to precisely what this means, but the key words are "setting capital requirements." A capital requirement restricts how much financial activity an institution can engage in per unit of cash that it holds in reserve (banks call this a reserve ratio). A requirement/ratio of 10 percent would allow 90 percent of the institution's assets to be in something other than cash. The rather lax capital requirements the twins enjoy — half that of their competitors — is precisely what has allowed the twins to undercut their competition and become so big in the first place. How this will play out is simply an unknown at this point — we have relayed to you all the details that are publicly available at this time — but what we do know is that the Federal Reserve has for decades been attempting to get the necessary regulatory powers specifically so that it could impose conditions upon the twins to address precisely the problems discussed earlier in this piece. If now, in a time of brewing crisis, the Fed finally gets its way and is able to act upon such newfound powers, the overall picture in the U.S. market could change demonstrably — and rapidly. STRATFOR does not claim that the Federal Reserve is infallible, but it alone among the institutions in the U.S. government has the authority, means and credibility to fix what is wrong with the twins — most notably the sheer size of market share they hold in the industry — assuming it is granted the legal competency to do so. Bear in mind that the Federal Reserve is an institution with a record of leveraging its powers in creative ways. A case in point was the "bailout" of Bear Stearns. In that action the Fed was criticized for not allowing the market to take its course and allow an over-leveraged firm to fail. Yet the last time we checked, Bear Stearns was no more. The mix of policies that the Fed used allowed the overall system to continue functioning, but at the cost of the liquidation of the player who was symptomatic of the problem. Right or wrong, the Fed was the most powerful single force in the global economy before
it became the regulator of the non-bank financial players in the United States. In just the past few months the Fed has developed regulatory power over the investment houses, and now it appears it may be doing the same for Fannie Mae and Freddie Mac. Which means that the entire foundation of the American — and dare we say global — economy could soon be managed out of a single post office box. Whether this is a "good" or "bad" thing lies in the eye of the beholder — and in the competency of any particular Fed board. But that is an issue to ponder for another day. In the shorter term the Fed may about to segue the twins into a more restrictive regulatory structure — even if only in the case of capital requirements — that could revolutionize the entire sector and force the twins to compete on their merits. At that point the twins would have to start acting like real companies or face losing their massive market share to more efficient players.