Fannie and Freddie Bailout News

Fannie, Freddie and You: What It Means to the Public (Sept 7 NYT)

So what does the federal takeover of two mortgage finance giants mean to consumers?

Mortgage rates may fall a bit initially but probably not enough to halt the decline in home prices anytime soon. Some delinquent borrowers may have a better shot at modifying their loans and ending up with lower fixed payments. And the rules on new mortgages could slightly change.

Oh, and the federal government will help pay for it all, using your tax money.

There’s not much 'reason' for any of the market reactions we saw today. Those have to be attributed to something other than a change in the fundamental landscape. To begin with, FNM and FRE always had implicit backing by the federal government, so making it explicit should, on the surface, do little to make the broad stock market rally. But rally it did. Here’s a partial list of other things that bailing out FNM and FRE won’t accomplish:

  1. It won’t stop house prices from sliding down further.
  2. It won’t create any new jobs.
  3. It won’t resuscitate the already insolvent banks.
  4. It won’t help the federal budget deficit; it will make it far worse.

However it DOES represent money that will not be used to fix bridges, repair our electrical grid, or send kids to college. And it DOES represent a bailout of everybody who is holding FNM and FRE paper (bonds and MBS and such).

How much money is all this going to cost? I figure somewhere between $250 billion and $750 billion before all is said and done. The next article does the math.

Deja Vu (Again)  (July 7 – Hussman Funds)

As I noted in July “it is reasonable to expect that at least 4% of the mortgages held or guaranteed by Fannie Mae and Freddie Mac will ultimately fail by 2009 (when the open-ended commitment of the government sunsets). Assuming a 50% recovery rate, which is about what banks are running on foreclosure recoveries lately, the losses on the retained mortgages and the guaranty books of Fannie and Freddie would already exceed $100 billion.” Unfortunately, that $100 billion loss projection was based on the premise that the government's commitment would extend only until January 2009, so I only included in that 4% the mortgages already in foreclosure and just a portion of the delinquent ones.

With that January 2009 “sunset” provision now gone, I expect that U.S. taxpayers will be on the hook for about $250 billion in losses. Look – 9.16% of U.S. mortgages are already delinquent or in foreclosure, with the likelihood of further delinquencies and foreclosures in the coming quarters. On a $5.2 trillion book of mortgage loans between Fannie and Freddie, and a prevailing recovery rate of 50% on foreclosed properties, an overall loss of about 5% of this book, or about $250 billion, is a fairly conservative expectation.

I happen to agree with Mr. Hussman here in the timing and direction of this. But $250 billion is pretty much my floor on the costs. I happen to think that we’ll experience something closer to a 10% to 15% default rate, which would yield a $500 billion to $750 billion loss estimate. But that will take a couple of years to unfold. I happen to think that $250 billion is a reasonable estimate of losses over the next year, which happens to coincide with the government fiscal calendar. If we add $250 billion to the US government’s already-estimated $500 billion deficit projection for FY 2009, we get to jack their total borrowing take for next year to around $750 billion – a record by far, just not the sort you want to be making right here.

And this assumes that there isn't further deterioration in the area of income tax receipts, an assumption I am not willing to make. If things go bad on this front, too, a $1 trillion dollar borrowing need is not unthinkable.

Couple this vast need to borrow with declining imports, and suddenly it’s reasonable to ask where all this money is going to come from. Domestic savings? No, that’s not likely. Foreign private parties? No, that’s not likely either.

This leaves official CB intervention to plug the gap. And this is what just happened this weekend.  We threw ourselves on the mercy of strangers. I sure hope we haven’t done anything lately to make them mad.

Fannie, Freddie Credit-Default Swaps May Be Settled (Sept 8 Bloomberg)

Sept. 8 (Bloomberg) -- Investors may be forced to settle contracts protecting more than $1.4 trillion of Fannie Mae and Freddie Mac bonds against default after the U.S. seized control of the companies in a bid to bolster the housing market.

Thirteen "major" dealers of credit-default swaps agreed "unanimously'' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today. Market makers for the privately traded contracts will discuss how to settle them in a conference call at 11 a.m. in New York, the document said.

"This is a big deal,'' said Sarah Percy-Dove, head of credit research at Colonial First State Global Asset Management in Sydney. "The market is not experienced at settling a credit event for a name of this size, so it is a bit of an unknown.''

A credit-default swap is a derivative agreement where two parties place a bet on whether a particular bond will enter default or not. If the bond goes into default, the writer of the CDS pays the face amount to the buyer of the CDS and then takes possession of the bond. Normally if a bond goes into default, it suffers a pretty horrendous loss in value.

In this case, I am not so sure that much will be gained or lost by either party in this mess. The FNM/FRE bonds are still trading pretty close to full value (because of the government bailout/backstop), so all that will really happen here is that bonds and money will trade hands at close to parity.  Still, it's a pretty big pile to have to unravel.

This is a companion discussion topic for the original entry at

[quote]Why The Fannie-Freddie Bailout Will Fail
by Martin D. Weiss, Ph.D. 09-08-08
With yesterday’s announcement of the most massive federal bailout of all time, it’s now official: Fannie Mae and Freddie Mac, the two largest mortgage lenders on Earth, are bankrupt.
Some Washington bigwigs and bureaucrats will inevitably try to spin it. They’ll avoid the "b" word with vengeance. They’ll push the "c" word (conservatorship) with passion. And in the newspeak of 21st century bailouts, they’ll tell you "it all depends on what the definition of solvency is."
The truth: Without their accounting smoke and mirrors, Fannie and Freddie have no capital. The government is seizing control of their operations. Their chief executives are getting fired. Common shareholders will be virtually wiped out. Preferred shareholders will get pennies. If that’s not wholesale bankruptcy, what is?
Some Wall Street pundits and pros will also try to twist the facts to their own liking. They’ll treat the bailout like long-awaited manna from heaven. They’ll declare that the "credit crisis is now behind us." They may even jump in to buy select financial stocks. And then they’ll try to persuade you to do the same.
The reality: This was the same pitch we heard in August of last year when the world’s central banks made a coordinated attempt to rescue credit markets with massive injections of fresh cash. It was also the same pitch we heard in March when the Fed bailed out Bear Stearns. But each time, the crisis got progressively worse. Each time, investors lost fortunes.
Together, both Washington and Wall Street are trying to persuade you that, "no matter what, the government will save us from financial disaster." But the real lessons already learned from these events are another matter entirely:
Lesson #1. Each successive round of the credit crisis is far deeper and broader than the previous.

  • In 2007, the big news was big losses; in 2008, it’s big bankruptcies.
  • In March, the failure of Bear Stearns shattered $395 billion in assets. Now, just six months later, the failure of Fannie Mae and Freddie Mac is impacting $1.7 trillion in combined assets, or over four times more. And considering the $5.3 trillion in mortgages that Fannie-Freddie own or guarantee, the impact is actually thirteen times greater than the Bear Stearns failure.
    Lesson #2. Despite unprecedented countermeasures, Washington has been unable to stem the tide.
    Yes, the Fed can inject hundreds of billions into the banking system. But if banks don’t lend, the money goes nowhere.
    Sure, the Treasury can inject up to $200 billion of capital into Fannie and Freddie. But if their mortgage portfolio is full of holes, all that new capital goes down the drain.
    And of course, the U.S. government has vast resources. But if the $49 trillion mountain of U.S. debts and the $180 trillion pile-up of U.S. derivatives are beginning to crumble, all those resources don’t amount to more than a band-aid and a prayer.
    Lesson #3. Shareholders are the first victims.
    Bear Stearns shareholders got wiped out. Fannie and Freddie Mac shareholders are getting wiped out. Ditto for shareholders in any of Detroit’s Big Three that go belly-up, any bank taken over by the FDIC or any insurer taken over by state insurance commissioners.
    The Next Lesson:
    The Primary Mission of the Fannie-Freddie
    Bailout Will Ultimately End in Failure

    Most people assume that when the government steps in, that’s it. The story dies and investors shift their attention to other concerns. In smaller bailouts, perhaps. But not in this Mother of All Bailouts.
    The taxpayer cost for just these two companies — up to $200 billion — is more than the total cost of bailing out thousands of S&Ls in the 1970s. But it’s still just a fraction of the liability the government is now assuming.
    First, because the number of home foreclosures and mortgage delinquencies has now surged to a shocking four million — and a substantial portion of the massive losses stemming from this calamity have yet to appear on Fannie’s and Freddie’s books.
    Second, because the U.S. recession is still in an early stage, with surging unemployment just beginning to cause still another surge in foreclosures and mortgage delinquencies.
    Third, even before Fannie and Freddie begin to feel the full brunt of the mortgage and recession calamity, their capital had already been grossly overstated.
    Indeed, right at this moment, while Wall Street analysts are trying to evaluate the details of a bailout plan that’s supposed to save them, regulators and their advisers are poring over the Freddie-Fannie accounting mess they’re supposed to inherit. According to Gretchen Morgenson and Charles Duhigg’s column in yesterday’s New York Times, "Mortgage Giant Overstated the Size of Its Capital Base" …
  • Freddie Mac’s portfolio contains many securities backed by subprime and Alt-A loans. But the company has not written down the value of many of those loans to reflect current market prices.
  • For years, both Freddie and Fannie have effectively recognized losses whenever payments on a loan are 90 days past due. But in recent months, the companies saidthey would wait until payments were TWO YEARS late. As a result, tens of thousands of other loans have also not been marked down in value.
  • Both companies have grossly inflated their capital by relying on accumulated tax credits that can supposedly be used to offset future profits. Fannie says it gets a $36 billion capital boost from tax credits, while Freddie claims a $28 billion benefit. But unless these companies can generate profits, which now seems highly unlikely, all of the tax credits are useless. Not one penny of these so-called "assets" could ever be sold. And every single penny will now vanish as the company goes into receivership.
    In short, the federal government is buying a pig in a poke — a bottomless pit that will suck up many times more capital than they’re revealing. My forecast:
    Just to keep Fannie and Freddie solvent will take so much capital, there will be no funds available to pursue the primary mission of this bailout — to pump money into the mortgage market and save it from collapse. That mission will ultimately end in failure.
    The Most Important Lesson of All:
    As the U.S. Treasury Assumes
    Responsibility for $5.3 Trillion in Mortgages,
    It Places Its Own Borrowing Ability at Risk

    The immediate reason the government decided not to wait any longer to bail out Freddie and Fannie was very simple: All over the world, investors were beginning to reject their bonds, refusing to lend them any more money. So the price of Fannie and Freddie bonds plunged, and the yields on those bonds went through the roof.
    As a result, to borrow money, Fannie-Freddie had to pay higher and higher interest rates, far above the rates paid by the U.S. Treasury Department. And they had to pass those higher rates on to any homeowner taking out a new home loan, driving 30-year fixed-rate mortgages sharply higher as well.
    Now, with the U.S. Treasury itself stepping in to directly guarantee Fannie-Freddie debts, Washington and Wall Street are hoping this rapidly deteriorating scenario will be reversed.
    They hope investors will flock back to Fannie and Freddie bonds.
    They hope investors will resume lending them money at a rate that’s much closer to the Treasury rates.
    And they hope Fannie and Freddie will again be able to feed that low-cost money into the mortgage market just like they used to.
    In other words, they hope the U.S. Treasury will lift up the credit of Fannie and Freddie.
    There’s just one not-so-small hitch in this rosy scenario: Fannie’s and Freddie’s mortgage obligations are just as big as the total amount of Treasury debt outstanding. So rather than the Treasury lifting up Fannie and Freddie, what about a scenario in which Fannie and Freddie drag down the U.S. Treasury?
    To understand the magnitude of this dilemma, just look at the numbers …
  • Mortgages owned or guaranteed by Fannie and Freddie: $5.3 trillion.
  • Treasury securities outstanding as of March 31, according to the Fed’s Flow of Funds (report page 87, pdf page 95): Also $5.3 trillion.
    If Fannie’s and Freddie’s obligations were equivalent to 10% or even 20% of the U.S. Treasury debts, the idea that they could fit under the Treasury’s "full faith and credit" umbrella might make sense. But that’s not the situation we have here — Fannie’s and Freddie’s obligations are the equivalent of 100% of the Treasury’s debts.
    And it’s actually worse than that:
  • Foreign investors, the most likely to dump their holdings if they lose confidence in the United States, hold an estimated 20% of the Fannie- and Freddie-backed mortgages outstanding. But …
  • Foreign investors own 52.7% of the Treasury securities outstanding (excluding those held by the Fed).
    So based on the above stats, Treasury securities are actually more vulnerable to foreign selling than Fannie and Freddie bonds.
    What happens if the international mistrust and fear afflicting Fannie and Freddie bonds infects U.S. Treasury bonds? Foreign investors would start dumping Treasury securities en masse. They’d drive Treasury rates sharply higher. And they’d wind up forcing Fannie and Freddie to pay much higher rates for their borrowings after all.
    How will you know? Just watch the all-critical spread (difference) between the yield on Fannie-Freddie bonds, considered lower quality, and the yield on equivalent government bonds, considered high quality. Then consider these two possibilities:
  • If that spread narrows mostly because Fannie and Freddie interest rates are coming down toward the level of the Treasury rates, fine. That means the immediate goal of the bailout is being achieved. BUT …
  • If the spread narrows mostly because Treasury rates are going up toward the level of Fannie’s and Freddie’s rates, that’s not so fine. It not only means a failure to achieve the immediate goals, but it will also imply that the entire Fannie-Freddie bailout is backfiring on the Treasury.