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Van Order
  Robert Van Order
 

Why the U.S. Took Control of Fannie Mae and Freddie Mac

9/15/2008 --

Ross professor brings unique perspective as former chief economist at Freddie Mac.

The U.S. government, in a historic move September 7, 2008, took over mortgage giants Fannie Mae and Freddie Mac, ousting the CEOs of both companies and laying out plans to invest up to $200 billion in capital to shore up their finances. Both companies, which were privately held but were government sponsored enterprises chartered by Congress, struggled of late as home values crashed and the value of mortgages they held plummeted. Between them, Fannie Mae and Freddie Mac own or guarantee more than $5 trillion in mortgages, almost half of those in the United States. The U.S. Treasury Department in July received the authority to invest capital and seize control of Fannie and Freddie, if necessary. Treasury Secretary Henry Paulson, after saying in July there were no plans to act on the authority, felt it was time to move in this month as investor nerves continued to rattle.

Ross School of Business Professor Robert Van Order, a former chief economist at Freddie Mac, talks about why Secretary Paulson took action now and the implications for the future of the two companies.

When Congress, earlier this summer, gave the U.S. Department of Treasury the authority to do what it just did, Secretary Paulson said then he had no plans to use those powers. What changed between then and now?
Van Order: I think they were afraid of a bank run. I don’t think that there has been any particular news about Fannie and Freddie, per se. I think what happened recently is that investors began to get a little skittish, particularly foreign investors. And I think Treasury was trying to move ahead of the market and nip any sort of panic in the bud. They especially wanted to keep Fannie and Freddie open, because they've been a big deal. There aren’t many alternatives left to buy mortgages. The subprime market is pretty much gone and the market for jumbo loans (loans above the limit allowed for Fannie and Freddie to purchase) has become relatively expensive.

So what they did was two things. They didn't actually take the company over in an economic sense. Basically what they did was make an implied guarantee more or less explicit. The second thing is that they didn't do much to either company's operations, again because they wanted to the keep the market going, and you don't want a lot of transition and a lot of turnover in the middle of a potential crisis. My guess is what's going to happen is Fannie and Freddie will operate on a day-to-day basis similarly to what they were doing before this happened. Treasury has appointed a new CEO for each company, but in terms of the way they operate, buying mortgages and funding them, it will be about the same. I think there will be some constraints on risk taking. Will they take more risks? I don't think they were going to do that anyway, but they could have. Then they'll wait a while and see.

What, ultimately, will happen to Fannie and Freddie?
Van Order: I think the best bet is they'll muddle through, but they won't have enough capital to meet their ratios in a year or so. And then they'll have to decide what to do. Treasury will probably inject capital, and that'll help meet the ratios. One possibility is that they will go back to what they were under the new regulatory structure. They'll get a board and have a permanent CEO. I also think, in any event, that the new administration will take up the issue in a broader sense. Even if they survive there will be adjustments to capital regulations.

Why make this move now? Was it simply the uncertainty of what it would take to shore up their expected capital shortfalls?
Van Order: It's uncertainty. We don't worry about bank runs anymore because we have deposit insurance. But when there are bank runs, and we've seen one in the UK last year, you never know exactly when they're going to start. In the case of Fannie and Freddie the guarantee is only implicit. The problem with investors is, at what point do they decide, “I just don't have confidence that the guarantee is there, I don't know exactly what's going on, so I'm going to take my money and put it into treasury bonds, or AAA corporations.” And you don't always know when traders will act. It may be a story in a newspaper, it may be a rumor, it may be nothing you can point to at the time. Treasury wanted to prevent that.

What about the current shareholders of Fannie and Freddie?
Van Order: Treasury has positioned itself ahead of the shareholders. The stock has dropped to almost nothing. There are a couple of things going on. One is that neither the preferred nor the common shareholders are going to get any dividends. The other thing is Treasury got some warrants. So if the stock goes up, the shareholders are going to be diluted again. I think this is a reasonable way of structuring it. While it leaves the shareholders in bad shape, if you think of the company and its role, it is left with a reasonable chance of coming out of it.

So you think this move will help? Van Order: Yes. It was designed to keep the market open and it has done that. The stock market was up (the day of the announcement), and Fannie Freddie borrowing rates have fallen. There's been a sense all along that their debt and mortgage-backed securities were guaranteed, but it was never legal. I think this lends some clarity, and clarity helps, particularly in the mortgage market where so much of it, especially the subprime securities, is unfathomable to a lot of people. That we understand these securities now, I think, is a big deal.

Why so important to keep the mortgage securities market open?
Van Order: Because right now there isn't much of a substitute for it. About 90 percent of all American adults are homeowners at some point in their life and well over half of those take on a mortgage at some point in their life. It's a part of market that most everybody needs in some way, and it's an important part of the financial system. And right now, of course, house prices are falling and markets almost everywhere are lousy. One of the things you don't want at the same time that housing is doing lousy is to make it worse by making it harder than you need to for people to get loans. A huge part of the mortgage originators aren't banks, in the sense we think of commercial banks. It's mortgage banks, mortgage brokers, and a lot of institutions that never intended to hold them. In the short run, ginning up the apparatus to originate and hold the loans wouldn’t be easy.

What are the main risks?
Van Order: To the government, the risk is that house prices will drop more than anyone thinks and defaults will get really big, Fannie and Freddie won’t be able to go survive, and they'll have to be put into receivership. Then they'll have to be dealt with and that's when the government has to put out serious money. Right now they're buying some securities; they'll be buying stock and getting some warrants. Who knows how that will play out? They could make money; though that’s not the most likely outcome.

How likely is it that house prices will fall too much for them to survive?
Van Order: I looked at the stress test that Freddie did, and they're projecting a 20 percent decline in home prices, which is not generous. They seem to be in a position where their capital, despite some of the questions about its content, will, along with their income, be enough for them to survive, but it can be a close call.

So does this it make the election of the next president more critical to the housing market?
Van Order: Possibly. I think it's too early to tell for sure what either candidate wants. McCain seems more interested in drastic changes. Traditionally, Democrats have been more supportive of Fannie and Freddie and Republicans more critical.

How might the structure of Fannie and Freddie change or be reformed?
Van Order: One possibility is that they may not take a new form, that between the government's injection and the capital they have, they'll muddle through. Not unlike Chrysler. That's one kind of model. The other possibility is that there are two more drastic directions. One is to be more like a government agency, like the Federal Housing Administration and Ginnie Mae, and the other is privatization. Those have their costs, too. The other direction is privatization, which means doing away with the charters they have and starting from scratch. The problem you have when they do that is that there wasn't a legal guarantee anyway. The question of privatizing is: do we change the charter but have the same problem --- too big to fail? The truly private parts of the market i.e., --- subprime --- have been the worst and caused the most disruption. The other, semi-private part, the banks, also have guarantees, which we know can be expensive. Even if the government doesn’t make a move the markets will be much more conservative. But 10, 20, 30 years from now, there will be something different. There always is.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu