Between the lines: Bush faces dilemma over fate of Fannie and Freddie

Published on Tuesday 19 August 2008 21:09

REFERENCES to the wonderfully nicknamed Fannie Mae and Freddie Mac, the main backers of US home mortgage finance, are apt to produce ribald comments rather than financial concern in Britain. But think again: the collapse in the share price of both organisations in the past few days presages yet another twist in the credit crunch saga. Fannie and Freddie are about to become the US equivalent of Northern Rock for the Bush administration.

At the weekend, Barron's, the authoritative US financial weekly, stoked shareholder fears about both companies by suggesting that the Bush administration was about to take them over. Both mortgage lenders have been battered by record delinquencies and rising losses as the US housing market slumped. Their recent losses total $15 billion, causing shares to drop by around 90 per cent this year.

But why should the markets react adversely to the announcement that the US Treasury is going to save Fannie Mae and Freddie Mac? Indeed, following the Barron's article, US bank shares have nosedived across the spectrum.

First, some history. The Federal National Mortgage Association – abbreviated to FNMA, hence the sobriquet – was set up in 1938 under Franklin Roosevelt's New Deal to make homes more affordable for working-class Americans. Fannie Mae does not provide home loans itself. Instead, it deals in the secondary market, buying mortgages from the direct lenders and so shouldering the risks of default.

This allows the lending banks to provide even more mortgages. In theory, this is very efficient way of socialising risk and smoothing out bumps in private mortgage provision. But it contains the implicit moral hazard of allowing private mortgage suppliers to make risky loans and pass them on. In retrospect, the only surprise is how long it took for this to occur.

In the late Sixties, Fannie Mae was taken off the US government books as a way of removing its liabilities from appearing in the national debt – a classic political fiddle. Instead, Fannie was turned into a private company with shareholders – but termed a "government sponsored enterprise".

This vague phrase was meant to imply a government guarantee of Fannie's liabilities, but nothing was legally binding. Fannie Mae, though now private, also received privileges denied to other lenders: exemptions from state and local taxes, reduced capital requirements, and the ability to borrow money cheaply. The profits rolled in.

Excited by this seemingly costless way of funding home-ownership, Congress set up a duplicate organisation, Freddie Mac, in 1970. This gave the impression of competition. Today the two companies own or guarantee half of America's $12 trillion in mortgage debt. Given their aura of public service and federal "sponsorship", Fannie and Freddie often avoided serious scrutiny. Latterly, they became key actors in creating the subprime mortgage scandal and the ensuing credit crunch.

In the boom of the 1990s and early 21st century, Fannie and Freddie formed an overly-cosy relationship with Wall Street, which made fat fees from issuing debt for the two companies, or from selling them mortgages of dubious quality.

At the same time, Fannie and Freddie's vast lobbying machine in Washington hired politicians, or their family and friends, in a bid to discourage any regulations that might involve undue oversight of their business practices.

In 2004, Fannie's senior management was caught engaging in questionable accounting practices that led to an overstatement of its earnings and an understatement of its risk. An investigation review by the Securities and Exchange Commission confirmed the allegations.

As the subprime crisis unfolded last year, it became obvious that Fannie and Freddie had been left holding the parcel of defaulting mortgages. Few will cry for the shareholders who had made easy money in the good times. But if Fannie and Freddie run out of cash, they cannot underwrite the US mortgage market and the housing crisis will turn into a catastrophe.

As it is, with most interbank lending frozen, Fannie and Freddie have issued the vast majority of mortgage securities sold in the US market in the last six months. To help, in March, the Bush administration eased the regulatory regime on Fannie and Freddie, a move which would allow the two companies to invest a staggering $200 billion extra in mortgages.

However, to do so, Fannie and Freddie will have to get the cash from somewhere. But as their losses mount, raising those funds looks increasingly problematic. Even finding the cash to cover growing liabilities may be difficult. On 7 July, a Lehman analyst's report claimed that, if normal accounting rules were applied, the companies needed to raise $75 billion. The inference was that Fannie and Freddie were technically insolvent.

In a bid to help, in mid July, Congress approved a rescue package that empowers the Bush administration to inject billions of federal dollars into the companies. In effect, renationalise them and plug the hole in the balance sheet with massive amounts of taxpayers' cash. However, this was actually all smoke and mirrors. Bush does not want to take over Fannie and Freddie.

For a start, after signing so many blank cheques in the past year, it is unlikely that the federal budget could take on financing the whole US mortgage market, which is what Fannie and Freddie do. Second, nationalising Fannie and Freddie will put their combined debts back on the federal balance sheet. Instead, Bush hoped this show of support for Fannie and Freddie would help restore market confidence in the two companies. It seems to have done the opposite.

When push comes to shove, Bush will nationalise Fannie and Freddie and let Obama deal with the mess. However, the real impact of the unravelling of the two companies lies in the further corrosion of confidence in the US financial system. Hence the latest fall in bank shares.

It will be difficult to avoid a restructuring of Fannie Mae and Freddie Mac. But rather than react to events, it would be better to act now and trade federal refinancing for a major overhaul of their role and management. The obvious long-term solution is to break up Fannie and Freddie and pave the way for a secondary mortgage market free from federal apron strings. When private risk is palmed off on the public purse, financial disaster always lurks round the corner.