Mon 8 Sep 2008
On Sunday, Federal Government officially took over Freddie Mac and Fannie Mae. Secretary Paulson had previously called this possibility, firing the bazooka in the pocket. Fannie and Freddie had been under intense financial duress as result of the U.S. housing slowdown/meltdown.
For those who don’t know what Freddie and Fannie are. Let me first describe them as best I can. While Freddie and Fannie are two different entities, they serve an identical function. Both are Government Sponsored Entities (GSE) charted to buy and securitize mortgages. Both corporations buys individuals mortgages and then sell bond like securities that backed by those mortgages. Each collects small fee for guaranteeing the principle and interest payment of those securities they sell. While explicity those guarantees are only as good Freddie and Fannie themselves, it has always been assumed standing behind the curtain was the full faith of the U.S. Government. It has been widely and correctly believed that Federal Government would not allow either Fannie or Freddie fail.
Why have Fannie and Freddie at all? Can’t private corporations serve the same role? They have and they do. Commerical banks routinely securitize mortgages. Bear Stearns certainly got into alot of trouble doing that. The benefit of having GSE serve that role is that a GSE can do so more cheaply because of the government guarantee. Fannie and Freddie pioneered the mortgage back security industry, creating a viable liquid market. They still own or guarantee over half of the 12 trillion U.S. Mortgage market. Most people who have any kind of mortgage can thank Fannie and Freddie, and implicitly the U.S. Government for making borrowing cheaper. And until now, that implicit rat subsidy had no cost.
So what does the bailout meant?
Because Freddie and Fannie have been under such duress as of late, neither entitity had been able to do much of what they were created to do, buy mortgages. With the bailout, the cloud over their business should lift. The conventional wisdom is that mortgage rates will be lower as the implicit guarantee on the bonds issued by Fannie and Freddie has become explicit. Personally, I’m doubtful how large that impact will be. Some speculate that it might be as much as 1% decline. I find that hard to believe as that implict guarantee was almost universally accepted truth. That said I do think there will be some loosening. Fannie and Freddie were capital depleted previous to this move and were unable to do as much business as they probably should’ve.
Who Gets Bailed Out?
It’s still early, but the intial evidence indicates that shareholders will be wiped out as it should be. Bond holders should benefit. Taxpayers in the end will have the foot the bill for delinquent homeowners. While unfortunate that many of those responsible for current problem will have pay for the excess of thew few (greedy bankers, greedy home flippers, uninformed homeowners), I guess I believe in the end we are our brother’s keeper even as much we may choose not to be. If things work perfectly, responsible taxpayers will fair OK. The federal government is actually taking an ownership stake via preferred shares and even has a right to buy common shares.
