Government Rescues Mortgage Giants Fannie Mae and Freddie Mac
Unprecedented move to intervene was necessary, say Ross professors.
Ann Arbor -- President Bush signed into law a bill to shore up mortgage giants Fannie Mae and Freddie Mac July 30 after shares of both housing finance companies plunged and investor concern about the size of credit losses surged. Fannie and Freddie, known as government-sponsored entities (or GSEs), own or guarantee more than $5 trillion in mortgages, almost half of those in the United States. The sweeping new legislation pledges financial aid to Fannie and Freddie even as it creates a new regulator that will have a greater say over how well-funded the two GSEs are. The law also offers affordable government-backed mortgages to homeowners at risk of foreclosure. In addition, the bill gives the Treasury authority to increase a longstanding line of credit for each, and allows it to buy shares of the companies, if necessary.
In the following Q&A, Ross School of Business professors Robert Van Order, a former chief economist at Freddie Mac, and Dennis R. Capozza assess the impact of this news and predict how it could affect the current housing crisis.
Will these moves will restore confidence in the system?
Van Order: Yes. They were substantively small moves that were mostly directed at liquidity. By that I mean that Fannie and Freddie are probably not insolvent in the sense of not being able to pay off their obligations, but there was a risk of a "run on the bank" in the sense of investors in their debt not being willing to buy it, or of spreads going way up. That hasn't happened. Their spreads aren't too bad and they have been able to sell their debt. But there is probably some need to make sure. There was also a lot of noise in the press about a government takeover and "technical insolvency" that needed to be addressed.
Capozza: It's gotten so bad that people fear a run on the banks, and that's causing a lot of problems across the country. It's not over. It's going to continue until they calm everybody down.
Was this the right thing to do?
Capozza: It was necessary. I've been saying for some time that there would be a major credit event, but I didn't think it would go this far. The present rate of default is unprecedented. In a little over a year, the rate of foreclosures started has doubled. In our data, which goes back to 1979, there has never been this kind of a jump. The financial system relies in large part on good faith. It just doesn't work if borrowers and lenders don't trust each other. The whole system shuts down when you lose that trust. They have to address the crisis of confidence in the financial system. Real estate represents about half the wealth in the United States. And about 70 percent of that is residential. So you're looking at an asset that an awful lot of people hold.
Van Order: Yes. It was not as big a deal as some commentators have suggested, but it does tell the market that the government is committed to keeping Freddie and Fannie, and in turn the mortgage market, open. A big part -- the dog that didn't bark -- was that there was no sense of a takeover of the two, and a lot of talk about keeping them shareholder owned.
These companies were chartered by Congress but were owned by shareholders, but was some sort of backing from the government always implied if push came to shove?
Van Order: Yes. Their debt has generally traded as AAA or AAA+ when, on its own, it would have been AA or AA-. The difference is the perception of a government guarantee. This wasn't a legal guarantee, like deposit insurance, but it has worked in much the same way.
The new law includes provisions that let Treasury offer Fannie and Freddie an unlimited line of credit. It also lets them buy stock in the companies. What are the implications of these moves?
Capozza: Well, the ultimate risk is that Fannie and Freddie may have to shut down. If they suffer excessive losses and can't meet capital requirements, they would have to stop buying mortgages, and they are the primary buyer of mortgages in the country. If Treasury were to refuse a line of credit when it was needed and Fannie and Freddie were forced to stop buying mortgages, a big chunk of the entire housing and mortgage markets would come to a standstill – it would have a huge impact.
Van Order: The "line of credit" isn't really a line of credit in the sense that it is not at Freddie and Fannie's option. Rather it allows Treasury to lend money to them if it wants to without getting permission. The increase is actually small and, of itself, not much of a move, but it shores up the perception of the implicit guarantee. Buying the shares is okay, but not especially likely. In any event, from a public policy perspective the stock isn't important. It's keeping the debt market open that matters.
But doesn't this put the taxpayers on the hook? Is it a good idea for the government to take a larger role in the mortgage business?
Capozza: Possibly, taxpayers would pick up some of the tab, but Fannie and Freddie are the only buyers of mortgages right now, and they earn fees from that. They'll probably regain solvency. I doubt the federal government will lose any money on the investments.
Van Order: The taxpayers always have been exposed. The government has directly or indirectly backed almost all mortgages since at least the 1950s. For a while this was government insurance, like FHA and then deposit insurance and the S&Ls. Now it is more via Freddie and Fannie. Even now the risk doesn't look all that big, especially given the alternatives.
The other piece is that the Fed has the authority now to give Freddie and Fannie access to the discount window, if necessary. Will this help assuage concerns of a short-term funding crisis?
Capozza: Well, it has so far. (A $3 billion debt auction by Freddie went smoothly after the plan was announced.) Will they use the discount window? I just don't know how bad their books are.
Van Order: It's probably not likely as they have their own ability to raise money short term. Knowing they can, however, seems to make the market happy.
Doesn't this give the Federal Reserve a bigger role in mortgage market?
Capozza: That's exactly what they want. I think they feel that they have been too constrained. Traditionally the Fed has not intervened in these areas, but they would like to have that authority now, because the banking system has changed. The Fed is looking for a bit more regulatory oversight for financial entities, including Wall Street, investment banks, and Freddie and Fannie.
Van Order: The burden, re: Fannie and Freddie really is Treasury, which is the entity that would have to act if there really were a bailout. The Fed doesn't regulate Fannie and Freddie. That is done by a separate agency, though that may be changing.
Robert Van Order is an adjunct professor of finance at Ross and an expert on real estate markets and mortgage securitization. Dennis R. Capozza is a professor of finance and real estate and the Dykema Professor of Business Administration at Ross. He is an expert on real estate and consumer finance.
Written by Terry Kosdrosky
Read more about Capozza and Van Order's research on the subprime debacle.
Listen to a related podcast with Van Order.
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Bernie DeGroat, (734) 936-1015 or 647-1847, firstname.lastname@example.org