Freddie Mac, Fannie Mae, and Covered Bonds

Real Estate

Freddie Mac, Fannie Mae, and Covered Bonds—Oh My!
By Dan Smith

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This month, I received a number of questions regarding the news on Freddie Mac and Fannie Mae. In particular, the questions most asked were, “Do you think they will fail? And, if so, what will happen to interest rates?”

Well, the truth is that Fannie and Freddie have issues. This is a bad market to be a mortgage company in, and there are going to be some losses for a quarter or two. However, when you turn on the news, you find sensationalized stories everywhere. For example, according to former St. Louis Federal Reserve President William Poole (as reported on Bloomberg News), “Freddie Mac owes $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules.” Sounds like the end, right? But in the same Bloomberg article, the Office of Federal Housing Enterprise Oversight (Fannie and Freddie’s regulator) said today, “it deemed Freddie Mac adequately capitalized.'' This means that Freddie appears to have enough in capital reserves to cover the cost of servicing that aforementioned debt. Hmm, the two statements don’t seem to add up. And to top it off, no one reporting on this story seems to have a clue about how to read a financial statement—but they sure appear to be having fun creating a frenzy. So what are the facts?

Between Fannie and Freddie, these two government-sponsored enterprises (GSE), own or guarantee about half the $12 trillion of mortgages nationwide. Both companies have assets totaling over $800 billion—and of that, each has capital reserves in excess of $40 billion. So while Fannie lost $2.5 billion last quarter, I do not see an eminent collapse of either giant. Much of that loss was a paper write down of value on some of Fannie’s assets to the tune of $4.3 billion, to comply with new accounting requirements. So without the paper write down, they were actually profitable? The real problem is more a crisis in confidence created, in large part, by the media. But make no mistake, that lack of confidence is a real issue in that it severely affects liquidity. If it isn’t addressed, it theoretically could become a self-fulfilling prophesy.

Enter Treasury Secretary Henry Paulson. He is proposing a temporary line of credit of some $25 billion, for both Fannie and Freddie to use as a last resort. The line would be open until December 2009—and then closed to further use. This is actually an excellent idea to restore confidence. It lets the financial markets know that the U.S. government will not allow a failure of either of these institutions. It is also brilliant because it is unlikely to ever be used, given the facts above. The nonpartisan Congressional Budget Office (CBO) seems to agree. In a story from CNBC, the CBO said that there is a "probably better than 50 percent" chance that the proposed new Treasury authority would not be used before it expired.

There are additional reasons why neither of these giants will fail. Both of these companies could sell stock to raise additional capital. They could also cut dividends, and/or let their portfolios run down, and/or sell off portions of that portfolio. In fact, the Wall Street Journal recently reported Freddie was currently considering all of the above. This tells me (and the reporter at the WSJ) that Freddie isn’t interested in any bailout whatsoever. Finally, there is the fact that with Fannie and Freddie responsible for 70 percent of the new home loans being written, there is no way on earth the U.S. government will allow any such collapse.