Treasury Secretary Paulson has decided that the risk of waiting is too much to bear for the economy and the mortgage market.  It is like a pre-packaged bankruptcy. The two agencies will be put under Federal control. The management and the boards of Fannie and Freddie will be replaced, the existing shareholders of common and preferred shares could be practically wiped out. The two entities will act business as usual buying up 70 percent of the mortgages written in the country. The government will inject capital through senior preferred shares. In addition, the Treasury will purchase mortgages from Fannie and Freddie. This way, the government has addressed both capital and liquidity issues. The housing and mortgage market should benefit from the actions. 

Why the Urgency?

Fannie and Freddie have combined equity of about $85 billion to own or guarantee mortgage assets of $5.2 trillion. The capital ratio is about 1.6 percent, a highly leveraged position by any standard. The New York Times reported that the agencies have overstated the capital. If fair market valuation is applied to the mortgage assets, the capital cushions become negative $45 billion for Fannie and negative $5 billion for Freddie. The government did not want to repeat the mistake of waiting until the last minute as it did with Bear Stearns. Too much is at stake both here and abroad.  

 

Unfortunately, the mortgage market has been deteriorating. S&P/ Case-Shiller index shows 18 percent fall in house prices and further declines are certain. As the mortgage market falls, Fannie and Freddie will suffer additional losses. This is one of the reasons for the Treasury acting now rather than waiting. Time is not on the side of Fannie and Freddie.

Earlier, Fannie was able to raise $7 billion in equity, but Freddie has not been able to. Sensing government rescue is approaching, no one wanted to invest in the sister agencies. Potential investors knew existing shareholders could lose almost totally once the government takes over.

Their shares lost more than 90 percent of its value this year. Moody’s lowered the ratings of the preferred shares of the agencies to near junk status. The outstanding preferred shares amount to $36 billion. Many financial institutions including JP Morgan, mutual funds and pension funds own the preferred shares.

By the end of September, Fannie and Freddie have to roll over about $500 billion in maturing debt. Should the rollover go badly, it would have a very negative effect on global financial markets considering many foreign investors including central banks own the Fannie-Freddie debt. Now the worries have diminished a great deal.

The cost of raising cash in the bond market for the agencies has been rising. Seeing the worsening financial picture of the mortgage giants, the spread of Fannie and Freddie yields over Treasury has been rising eventually translating into higher mortgage rates for homebuyers.

Treasury has been receiving a number of inquiries from the worried foreign central banks including Japan,Korea, Mexico, Middle East, etc. A number of central banks have loaded up on the agency debt believing theU.S. government stands behind them. Under the plan, the foreign investors should be protected even though some discounts on the bonds they own are possible depending on the direction of the interest rate.   

Injecting Capital

Capital will be injected overtime as necessary in the form of senior preferred debt. With the government bailout, the urgency to shore up capital has diminished. Any taxpayers’ money given to the agencies has a senior claim on existing shareholders, both common and preferred. As pointed out earlier, the existing shareholders could be wiped out. Certainly, dividend will be suspended even for the preferred holders. Since the preferred dividends are non-cumulative, it will be a while before any cash is paid out in the future.

Impact on Mortgage Markets

The mortgage market will breathe a sigh of relief. Without Fannie and Freddie buying or guaranteeing 70 percent of new mortgages, the market would be paralyzed. With government backing, the institutions should be able to borrow money at rates close to what the Treasury pays in the marketplace. The mortgage rate should be lower than it would be without the government guarantee.

Since the stabilization of the housing and mortgage markets is a prerequisite for economic rebound sometime in the future, economic outlook in the near term has improved.

Costs to the Treasury

The costs could add up to tens of billions of dollars. However, the government could fare well in its investments if the economy recovers and the value of the mortgages increases.

Another concern is the credit rating of the U.S. government. The U.S. Government has trillions of dollars of debt outstanding. With the takeover of Fannie and Freddie, the government will add trillions more to the burden since the Treasury will in fact guarantee all the Fannie and Freddie debt.

Even before today’s announcement, purchasing a credit-default swap for 10-year Treasury notes cost twice as much as the comparable German government bond.  Even though both government issues are rated “triple A”, clearly investors have had more concerns about the U.S. government.

As the U.S. government takes over Fannie and Freddie, the investor concerns could worsen. Some worry Uncle Sam could be downgraded. Since the U.S. economy has to borrow about $2 billion every single day to finance its deficits, this would create a big problem, let alone the higher cost of borrowing.

What to Do in the Long Run?

The agencies should be privatized as soon as practicable. In the past, the agencies have been neither “fish nor fowl”; they were for profit organizations benefiting from implied government backing. The mortgage giants should be split up into several pieces and auctioned off to the private sector. Once the umbilical cord is severed, the government should have no role, other than supervisory, in running the organizations.