FYI | Jul 14 2008
By Greg Peel
The Federal National Mortgage Association of the US has the acronym FNMA. Say that quickly, and you get “Fannie Mae”. So ubiquitous did the use of this nickname become that it was eventually adopted by the company when it listed on the New York Stock Exchange.
Fannie Mae was created in 1938 under President Franklin D. Roosevelt at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America. This was part of Roosevelt’s New Deal policy which followed the ravages of the Great Depression. For thirty years, Fannie Mae acted as the monopoly guarantor of the secondary mortgage market. In exchange for a fee, Fannie would guarantee payment of a mortgage and package up those mortgages into securities which it then sold as bonds.
In 1968, Fannie Mae was privatised and listed on the New York Stock Exchange. However, while it was fine for Fannie to hold a monopoly as a government body, it was not in America’s interest to allow a private monopoly. So when Fannie was listed, Congress also spun-off the Federal Home Loan Mortgage Corporation, or FHLMC. Somehow this acronym became “Freddie Mac”. From thereon in, Fannie and Freddie have operated as two competing “government-sponsored” mortgage lenders.
The term “government-sponsored enterprise”, or GSE, used in reference to both Fannie and Freddie, is a misleading one. It leads to the presumption that the two are ultimately guaranteed by the government, but this is not the case at all. In fact, the actual extent of the government “sponsorship” is a little grey, for while it has been stated that Fannie and Freddie don’t actually cost the American taxpayer anything there is a definite outgoing in the fiscal accounts to cover the cost of that sponsorship.
What the US government does do, at least, is relax the capital requirements on the lenders for the purposes of selling secondary mortgage bonds. As Fannie and Freddie need only hold about half the capital of truly private lenders, they can offer lower mortgage rates. This is thus the indirect way by which the US government helps it citizens to afford a mortgage. However, the mortgages that Fannie and Freddie can sell under this arrangement must be “conforming”. In short, they have to be “prime” mortgages, and they cannot exceed a certain dollar value. The limit on size varies from state to state, but the top end was previously US$417,000. Any mortgage above this level was called a “jumbo” loan and became the preserve of truly private lenders. In May this year the government increased the top level to a value of US$729,750 as part of its announced economic stimulus package.
Fannie and Freddie currently either hold or back some US$5.3 trillion of US mortgages, or about half the US mortgage market. One can thus appreciate just what sort of devastation would ensue were one or both to “go under” under the weight of credit security devaluation and profit write-downs. Both hold only half the capital backing of those mortgages as required by private lenders, some of which are either threatening to go under themselves or already have. The latest casualty was IndyMac – a California-based specialist in adjustable rate, no-proof-of-income-required mortgages (very “subprime”). IndyMac went under on Friday and thus created the second biggest ever bank failure in US history.
It appeared on Friday that Fannie and Freddie might also follow IndyMac down the tubes. There has been a great level of confusion in the market as to what “government-sponsored” means, and US Treasury secretary Hank Paulson has been stating loudly recently that he “supports” the two entities. However, when Paulson reiterated on Friday that he supports Fannie and Freddie, but added “in their current form”, the market took that to mean there would be no direct government bail-out, if it came to that. Both companies saw their shares fall by over 50% on the day, to levels over 90% below their 2007 peaks. Therein followed a bounce-back, because speculation grew that the Treasury or the Fed or someone would surely have to intervene. Fannie and Freddie were simply “too big to fail”.
In response to F’n’F’s near demise on Friday, Senate Banking Committee chairman Christopher Dodd stated on Sunday that the two have “more than adequate” capital, in fact “more than the law requires”. In the private world, such statements are usually taken as a sign of desperation and a run can often ensue. However, US Treasury officials and the US Fed spent the weekend having crisis talks over what to do about Fannie and Freddie. The last time such crisis talks occurred on a weekend, the subject was Bear Stearns.
The result of the crisis talks is that the Fed will now allow F’n’F, if required, to borrow funds from the New York Fed at the same 2.25% rate now afforded to commercial banks and investment banks. The US Treasury is also to seek Congressional authority to extend government lines of credit to the two, and/or to make an actual equity investment if necessary.
The point is, of course, to provide implicit government support in the hope that it would never be needed. With the government in their corner, potential shareholders can feel safer about buying Fannie and Freddie and thus prevent any run on capital. However, when it comes to the crunch it would likely be the mortgages that will be saved, not the shareholders. And a test of market confidence will come tonight when Freddie Mac is due to auction a total of US$3 billion of three and six-month mortgage securities.
When the Fed “saved” Bear Stearns, it did so by providing a loan to rescuing bank JP Morgan for US$30 billion. In exchange, the Fed took control of that value of Bear Stearns distressed mortgage securities. The reason the Fed would swap dodgy mortgage paper for real money (apart from a desire to prevent a total collapse of global financial markets) is that if it could calm the markets down the end result should be that a market for such paper would eventually return. Since March, the Fed has not marked down any of that paper, suggesting it has at least stabilised in value.
Now the Fed and the Treasury are at it again, trying to save not a “greedy” and foolish investment bank, but half the nation’s prime mortgages. Whenever such measures are taken, the US dollar loses even more of its value, for there is nothing currently propping up the government’s own balance sheet on the other side in return for these specific guarantees. The Fed itself also has a limited balance sheet, and that balance sheet had already become stretched before this latest debacle.
At the same time, the Federal Deposit Insurance Corporation has been forced to takeover and guarantee deposits of the aforementioned IndyMac bank. The FDIC currently has 90 regional banks on “failure watch”, and insuring IndyMac will cost 10% of the US$53bn Deposit Insurance Fund. That’s 10% for one bank, and maybe 89 more banks to go. That doesn’t bode well for the US dollar either.
Apart from the generally ominous concept of the US financial system collapsing, any interim devaluation of the US dollar has the unfortunate consequence of pushing up the price of dollar-denominated commodities, such as oil.
