Federal takeover of Fannie Mae and Freddie Mac

Fannie Mae headquarters at 3900 Wisconsin Avenue, NW in Washington, D.C.

The federal takeover of Fannie Mae and Freddie Mac refers to the placing into conservatorship of government sponsored enterprises Fannie Mae and Freddie Mac by the US Treasury in September 2008. It was one financial event among many in the ongoing Subprime mortgage crisis.

The director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III. on September 7, 2008 announced his decision to place two Government sponsored enterprises (GSEs), Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into conservatorship run by FHFA. United States Treasury Secretary Henry Paulson, at the same press conference stated that placing the two GSEs into conservatorship was a decision he fully supported, and said that he advised "that conservatorship was the only form in which I would commit taxpayer money to the GSEs." He further said that "I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction." The same day, Federal Reserve Bank Chairman Ben Bernanke stated in support: "I strongly endorse both the decision by FHFA Director Lockhart to place Fannie Mae and Freddie Mac into conservatorship and the actions taken by Treasury Secretary Paulson to ensure the financial soundness of those two companies."

Background and financial market crisis

Main articles: Financial crisis of 2007–2008 and Liquidity crisis of September 2008

The combined GSE losses of $14.9 billion and market concerns about their ability to raise capital and debt threatened to disrupt the U.S. housing financial market. The Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt; the debt portion alone is $1.6 trillion. The conservatorship action has been described as "one of the most sweeping government interventions in private financial markets in decades," and one that "could turn into the biggest and costliest government bailout ever of private companies".

With a growing sense of crisis in U.S. financial markets, the conservatorship action and commitment by the U.S. government to backstop the two GSEs with up to US$ 200 billion in additional capital turned out to be the first significant event in a tumultuous month among U.S.-based investment banking, financial institutions and federal regulatory bodies. By September 15, 2008, the 158 year-old Lehman Brothers holding company filed for bankruptcy with intent to liquidate its assets, leaving its financially sound subsidiaries operational and outside of the bankruptcy filing. The collapse is the largest investment bank failure since Drexel Burnham Lambert in 1990. The 94 year-old Merril Lynch accepted a purchase offer by Bank of America for approximately US$ 50 billion, a big drop from a year-earlier market valuation of about US$ 100 billion. A credit rating downgrade of the large insurer American International Group (AIG) led to a September 16, 2008 rescue agreement with the Federal Reserve Bank for a $ 85 billion dollar secured loan facility, in exchange for a warrants for 79.9% of the equity of AIG.

Worries continued about the solvency of country's largest savings bank, Washington Mutual, and it was put into receivership September 25, 2008.

Previous Attempts for GSE Reform

In 2003, the Bush Administration sought to create an agency to oversee Fannie Mae and Freddie Mac. While Senate and House leaders voiced their intention to bring about the needed legislation, no reform bills materialized. A Senate reform bill introduced by Senator John Corzine (D-NJ) (S.1656) never made it out of committee. At the time members of congress expressed faith in the solvency of Fannie and Freddie. Congressman Barney Frank (D-MA), for example, described them as "not facing any kind of financial crisis."

In 2005, the Federal Housing Enterprise Regulatory Reform Act, sponsored by Senator Chuck Hagel(R-NE) & co-sponsored by Senators Elizabeth Dole (R-SC), John McCain (R-AZ) and John Sununu (R-NH)[1], would have increased government oversight of loans given by Fannie Mae and Freddie Mac. Like the 2003 bill, it too died in committee. A full and accurate record of the congressional attempts to regulate the housing GSEs is given in the Congressional record prepared in 2005. Many attempts were made with only minor results.

Gerald P. O'Driscoll, the former vice president of the Federal Reserve Bank of Dallas, stated that Fannie Mae and Freddie Mac had become classic examples of crony capitalism. Government backing let Fannie and Freddie dominate the mortgage-underwriting. They returned some of the profits to the politicians - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."

Federal Housing Finance Agency and Treasury authority

The Housing and Economic Recovery Act of 2008—passed by the United States Congress on July 24, 2008 and signed into law by President George W. Bush on July 30 2008—enabled expanded regulatory authority over Fannie Mae and Freddie Mac by the newly established FHFA, and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac, limited only by the amount of debt that the entire federal government is permitted by law to commit to. The law raised the Treasury's debt ceiling by US$ 800 billion, to a total of US$ 10.7 trillion, in anticipation of the potential need for the Treasury to have the flexibility to support Fannie Mae, Freddie Mac, or the Federal Home Loan Banks.

Prior GSE support measures

The September 7 conservatorship was been termed by the Economist as the "second" bailout of the GSEs. Prior to the enactment of the Housing and Economic Recovery Act of 2008, on July 13, 2008, Treasury Secretary Henry Paulson announced an effort to backstop the GSEs based on prior statutory authority, in coordination with the Federal Reserve Bank. That announcement occurred after a week in which the market values of shares of Fannie Mae and Freddie Mac fell almost by half (from a previously diminished value of approximately half of year-earlier market highs). That plan contained three measures: an increase in the line of credit available to the GSEs from the Treasury, so as to provide liquidity; the right for the Treasury to purchase equity in the GSEs, so as to provide capital; and a consultative role for the Federal Reserve in a reformed GSE regulatory system. On the same day, the Federal Reserve announced that the Federal Reserve Bank of New York would have the right to lend to the GSEs as necessary.

Capital infusion by the Treasury

The agreement the Treasury made with both GSEs specifies that in exchange for future support and capital investments of up to US$ 100 billion in each GSE, at the inception of the conservatorship, each GSE shall issue to the Treasury US$ 1 billion of senior preferred stock, with a 10% coupon, without cost to the Treasury. Also each GSE contracted to issue common stock warrants representing an ownership stake of 79.9%, at an exercise price of one-thousandth of a U.S. cent ($ 0.00001) per share, and with a warrant duration of twenty years.

The conservator, FHFA signed the agreements on behalf of the GSAs. The 100 billion amount for each GSE was chosen to indicate the level of commitment that the U.S. Treasury is willing to make to keep the financial operations and financial conditions solvent and sustainable for both GSEs. The agreements were designed to protect the senior and subordinated debt and the mortgage backed securities of the GSEs. The GSEs' common stock and existing preferred shareholders will bear any losses ahead of the government. Among other conditions of the agreement, each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion.

FHFA initial actions as conservator

In the September 7, 2008 conservatorship announcement, Lockhart indicated the following items in the plan of action for the Federal Housing Finance Agency conservatorship:

1. On September 8, 2008, the first business day of the conservatorship, business will be transacted normally, with stronger backing for the holders of Mortgage Backed Securities (MBS), senior debt and subordinated debt.
2. The Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month, without capital constraints.
3. As the conservator, the FHFA will assume the power of the Board and management.
4. The present Chief Executive Officers (CEOs) of both Fannie Mae and Freddie Mac have been dismissed but will stay on to help with the transition.
5. Appointed as CEOs are Herbert M. Allison for Fannie Mae and David M. Moffett for Freddie Mac. Allison is former Vice Chairman of Merrill Lynch and for the last eight years chairman of TIAA-CREF. Moffett is the former Vice Chairman and CFO of US Bancorp. Their compensation will be significantly lower than the outgoing CEOs. They will be joined by equally strong non-executive chairmen.
6. Other management action will be very limited. The new CEOs agreed it is important to work with the current management teams and employees to encourage them to stay and to continue to make important improvements to the Enterprises.
7. To conserve over $2 billion annually in capital, the common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will continue to remain outstanding. Subordinated debt interest and principal payments will continue to be made.
8. All political activities, including all lobbying, will be halted immediately. Charitable activities will be reviewed.
9. There will be financing and investing relationship with the U.S. Treasury via three different financing facilities to provide critically needed support to Freddie Mac and Fannie Mae, and also to the liquidity of the mortgage market. One of the three facilities is a secured liquidity facility, which will be not only for Fannie Mae and Freddie Mac, but also for the 12 Federal Home Loan Banks that are regulated by FHFA.

Treasury support programs and credit facilities

Treasury Secretary Paulson on September 7, 2008 described four aspects of the U.S Treasury's support of the two government sponsored enterprises (GSEs) while under conservatorship of the FHFA:

1. "To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size."
2. The Treasury and the FHFA has established Preferred Stock Purchase Agreements, contractual arrangements between the Treasury and the conserved entities. "Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations.
3. The Treasury established "a new secured lending credit facility available to Fannie Mae, Freddie Mac, and also Federal Home Loan Banks. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July 2008, and will be available until those authorities expire in December 2009."
4. "To further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS ... Treasury will begin this program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.

National debt accounting

The on- or off-balance sheet obligations of the two GSEs, which are "independent" corporations rather than federal agencies, are just over $5 trillion, a significant amount when compared to the $9.5 trillion of officially reported United States public debt. The September 7, 2008 conservatorship and the subsequent planned Treasury infusion of capital support the senior liabilities, subordinated indebtedness, and mortgage guarantees of the two firms. Some observers see this as an effective nationalization of the companies that ultimately places taxpayers at risk for all their liabilities. The federal government follows specialized accounting standards set by the Federal Accounting Standards Advisory Board. The net exposure to taxpayers is difficult to determine at the time of the takeover and depends on several factors, such as declines in housing prices and losses on mortgage assets in the future. The Congressional Budget Office director Peter Orszag announced on September 9, 2008 that the CBO intended to incorporate the assets and liabilities of the two companies into their federal budget planning, due to the degree of government control over the entities. The White House Budget Director Jim Nussle, on September 12, 2008 indicated their budget plans would not incorporate the GSE debt into the budget because of the temporary nature of the conservator intervention.

Bloomberg reported that according to CMA Datavision of London that "five-year credit-default swap contracts on U.S. government debt increased 3.5 basis points on September 9 2008 to a record 18, up from 6 basis points in April," in reaction to concerns about the potential rise in U.S. debt from bailouts.

Market consequences

Bank reserves

Many commercial banks in the United States own Freddie and Fannie preferred shares. Those shares have had their dividends suspended, and are junior to the senior preferred stock issued to the Treasury in the restructuring of the two companies. The market value of the preferred shares plunged after the restructuring announcement and suspension of dividends. Banks will be required to write down the value of Freddie and Fannie preferred stock held in their portfolios, compounding capitalization concerns for certain U.S. banks. Gateway bank agreed to be bought out by Hampton Roads Bankshares Inc. to make up for a writedown of $40 million on its stock in Fannie and Freddie, which put it below regulatory requirements to be considered adequately capitalized.

Credit Default Swaps

In the credit default swap (CDS) market, the standard contracts typically used between parties to a swap define the action of placing Fannie Mae and Freddie Mac into conservatorship to be equivalent to bankruptcy, because of the change in management control. In CDS parlance, this is termed a credit event, and that triggers the settling of outstanding contracts for the derivatives, which are used to hedge or speculate on the potential risk that a company will default on its bonds. The two GSEs have approximately US$ 1.5 trillion in bonds outstanding, and since the market in credit default swaps is not public, there is no central reporting mechanism to verify how many credit default swaps are linked to those bonds. One estimate floated is US$ 500 billion, and that the entire CDS market has a notional value in the vicinity of US$ 62 trillion. Settlement on the contracts, will likely be the largest in the market's decade-long history. Credit-default swaps on Fannie and Freddie have been among the most actively traded the several months leading up to the conservatorship. "Thirteen 'major' dealers of credit-default swaps agreed 'unanimously' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds," according to a memo circulated by the International Swaps and Derivatives Association (ISDA) after the conservatorship announcement. The day after the conservatorship announcement, the International Swaps and Derivatives Association, which sets industry standardized contracts for financial derivatives and swaps, announced it was working on a protocol on how to evaluate and settle Fannie Mae and Freddie Mac credit default swaps.

Paradoxically (in relation to typical experiences when a company issuing bonds has a "credit event"), the value of the two GSEs bonds rose to the vicinity of par value after the conservatorship. This means, that some owners of swaps that were hedging against the risk of a bond default, may be worse off, since the value of the bonds may be higher than when they purchased the swap. Cash auctions are reported to be scheduled for October 2008 to settle CDS contracts in relation to the GSEs.

Reactions to the seizure

The immediate reactions in the finance markets on Monday September 8, the day following the seizure, appeared to indicate satisfaction with at least the short-term implications of the Treasury's intervention. Governor of the Bank of Japan Masaaki Shirakawa stated "We expect the action would lead to stabilize the U.S. [mortgage-backed securities] market, financial market and the international financial market." Governor of the People's Bank of China, China's central bank, Zhou Xiaochuan stated "From my point of view this is positive".

Effects on the subprime mortgage crisis

The effects on the subprime mortgage crisis have led the government to support the soundness of the obligations and guarantees on securities issued by Fannie and Freddie to obtain funds. Those funds are in turn used to purchase mortgages from originating banks. The continuing soundness of GSE obligations enhances market liquidity (loanable funds) in the following ways:

• Banks can be assured that Fannie and Freddie have funds to purchase conforming loans, so they can increase such lending. This improves liquidity in the mortgage market, lowering interest rates.
• Lower borrowing costs for banks typically increase the "spread" between the rate at which they borrow and which they lend. This increases bank profitability, shoring up bank liquidity and balance sheets further.
• Adjustable rate mortgage (ARM) rates are reduced, which lowers pressure on homeowners and reduces foreclosures. Lower rates also encourage new home purchases.
• The government's role as the primary investor allows a systematic loan refinancing process to be implemented. This should enable rapid loan adjustments or workouts for homeowners, which have been facing bottlenecks due to the requirement to have various investors approve the adjustments. For example, the government could rapidly push-down 45-year mortgage terms and fixed, low interest rates, enabling many more homeowners to stay in their homes. This will reduce foreclosures significantly, helping to stabilize home prices.
• The government can restructure mortgages so that the loan balance is reduced to the current market value, reducing the incentive for homeowners to "walk away" from the property.
• With home prices more stabilized, the value of mortgage-backed securities receives some upward support.

Financial condition of Fannie and Freddie prior to takeover

Over 98 percent of Fannie's loans were paying timely during 2008. Both Fannie and Freddie had positive net worth as of the date of the takeover, meaning the value of their assets exceeded their liabilities. However, Fannie's total assets to capital (leverage ratio) was about 20:1, while Freddie's was about 70:1. These numbers increase significantly if one includes all of the mortgage-backed assets they guaranteed. These ratios are considerably higher than investment banks, which leverage around 30:1.

However, there was concern that the GSEs' liquidity was insufficient to handle growing delinquency rates, such that although viable now, the scale of loss in the future would be sufficient that insolvency would occur and that knowledge of this future failure would induce immediate or near-immediate failure due to buyers refusing to buy debt. Both GSEs roll-over large amounts of debt on a quarterly basis and failure to sell debt would lead to failure due to lack of liquidity. A slower form of failure would be the issuing of debt at high cost (to compensate buyers for risk) and this would greatly diminish the earning power of both GSEs, rendering them unable to earn the money they would need to handle expected future losses. Both GSEs counted large amounts of deferred tax assets towards their regulatory capital, which were considered by some to be of "low quality" and not truly available capital. The deferred tax assets would only have value if the companies were profitable and could use the assets to offset future taxes. Both companies had experienced significant losses and were likely to face more over the next year or longer.

See also

• Subprime mortgage crisis
• United States housing bubble
• Mortgage GSE controversy

External links

Official web sites

• Federal Home Financing Agency (successor to the Office of Federal Housing Enterprise Oversight)
• United States Department of the Treasury
• Fannie Mae
• Freddie Mac
• Federal Home Loan Bank system

Background and reaction

• Quealy, Keven (September 15, 2008). "A Year of Heavy Losses". New York Times. Retrieved 2008-09-30. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help) (Graphic of change in market capitalization of major firms eleven months)
• Who's Holding the Debt. July 15, 2008. New York Times. (Graphic depicting the holders of GSE debt; note that there are twelve Federal Home Loan Banks, GSEs included in this graphic..)
• Schneiderman, R.M (2008-09-15). "How a Market Crisis Unfolded: Some of the key events in the upheaval". New York Times. Retrieved 2008-09-17. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help) (Graphic and interactive timeline.)

• Cooper, George (2008). The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy. Petersfield, Hampshire, U.K.: Harriman House. p. 208. ISBN 9781905641857. {{cite book}}: Cite has empty unknown parameter: |coauthors= (help)

• "Fannie, Freddie and Henry". Wall Street Journal. 2008-09-09. Retrieved 2008-09-09. {{cite news}}: Cite has empty unknown parameter: |1= (help) (Interactive timeline of Treasury Secretary Paulson's changing policy actions in relation to Fannie Mae and Freddie Mac – requires Flash.)
• Duhigg, Charles (2008-09-07). "As Crisis Grew, One Option Remained". New York Times. Retrieved 2008-09-08. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
• Labaton, Stephen (2008-09-08). "Reinventing Two Mortgage Giants: A Big Rebuild or a Teardown?". New York Times. {{cite news}}: |access-date= requires |url= (help); Unknown parameter |coauthors= ignored (|author= suggested) (help); Unknown parameter |http://www.nytimes.com/2008/09/09/business/09future.html?hp= ignored (help)
• Solomon, Deborah (2008-09-09). "Mortgage Bailout Is Greeted With Relief, Fresh Questions". Wall Street Journal. pp. A1. Retrieved 2008-09-09. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
• Solomon, Deborah (2008-09-08). "Mounting Woes Left Officials With Little Room to Maneuver". Wall Street Journal. pp. A1. Retrieved 2008-09-08. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
• Sorkin, Andrew Ross (2008-09-08). "Paulson's Itchy Finger, on the Trigger of a Bazooka". New York Times. Retrieved 2008-09-08. {{cite news}}: Cite has empty unknown parameter: |coauthors= (help)
• Stolberg, Sheryl Gay (2008-09-08). "Rescue of Mortgage Giants Displays Paulson's Clout". New York Times. Retrieved 2008-09-09. {{cite news}}: Cite has empty unknown parameter: |coauthors= (help)
• Delasantellis, Julian (2008-09-09). "Paulson placates China, Russia - for now". Asia Times Online. Retrieved 2008-09-09.