Research

Beleaguered Fannie Mae and Freddie Mac: Beacons of stability

President Bush has signed into law a housing package passed by Congress last week that authorizes the Treasury Department to spend federal funds to rescue Fannie Mae and Freddie Mac if necessary. In recent weeks, there's been widespread concern that the mortgage giants, which own or guarantee about half of the nation's mortgages, might be on the verge of collapse. Finance Professors Herbert Kaufman and Anthony Sanders at the W. P. Carey School of Business suggest a very different picture. Rather than faltering, Fannie Mae and Freddie Mac have actually been "beacons of stability" in the mortgage crisis that has roiled U.S. financial institutions of all stripes.

2008-07-22

President Bush has signed into law a housing package passed by Congress last week that authorizes the Treasury Department to spend federal funds to rescue Fannie Mae and Freddie Mac if necessary. In recent weeks, there's been widespread concern that the mortgage giants, which own or guarantee about half of the nation's mortgages, might be on the verge of collapse.

Finance Professors Herbert Kaufman and Anthony Sanders at the W. P. Carey School of Business suggest a very different picture. Rather than faltering, Fannie Mae and Freddie Mac have actually been "beacons of stability" in the mortgage crisis that has roiled U.S. financial institutions of all stripes.

The beginning

On July 9, mortgage industry giant Fannie Mae paid a record-high yield (relative to Treasury securities) on the sale of $3 billion in two-year notes. Investors demand a higher yield relative to Treasury securities when they're less confident about a company's ability to repay its debts.

The next day, in an interview for Bloomberg, former St. Louis Federal Reserve Bank President Bill Poole said "Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer."

That statement sent Fannie Mae and Freddie Mac's shares — which had already fallen the day before — to the lowest price in 17 years. The media took hold, with headlines shouting "crises," "meltdown," "failure" and "insolvency." Shares "plunged," "tumbled," "slid," and "cratered."

A different view

But are Fannie Mae and Freddie Mac really insolvent? W. P. Carey professors Herbert Kaufman and Anthony Sanders say no, they aren't. "While statements like Poole's — that Fannie Mae and Freddie Mac are de facto in a state of default — send shivers through the global economy, it is important to examine the serious delinquency rates at the two mortgage giants," said Anthony Sanders, professor of finance and real estate.

As of April, Sanders said, the rate of serious delinquencies on loans held by Freddie Mac was 0.81 percent. Fannie Mae's rate of serious delinquencies was 1.15 percent. Those rates compare to market-wide rates of serious delinquency of 1.47 percent for prime mortgages, 8.35 percent for Alt-A mortgages, and 20.74 percent for subprime mortgages. Fannie Mae and the smaller Freddie Mac either own or guarantee nearly half the entire market of U.S. home loans.

The companies purchase mortgages from lenders, keep some for their own investment portfolio, and resell some to Wall Street investors as collateralized debt obligations or asset-/mortgage-backed securities. "It is clear that Fannie and Freddie are the remaining source of stability and prudent underwriting practices among financial intermediaries," Sanders said. "It is their willingness to continue to purchase conforming loans that is keeping the U.S. housing market afloat."

Finance Professor Herbert Kaufman holds the same view. "Fannie and Freddie haven't been involved in subprime mortgages — those with all the defaults, the real source of the market crisis. Fannie and Freddie, instead, have mainly bought prime mortgages, with strong credit standards and fairly strict lending requirements.

Even in this bad mortgage market, the default rate on those prime mortgages is reasonable based on historical precedent. In fact, Kaufman said, Fannie Mae and Freddie Mac have weathered worse situations. "In the 1980s their losses actually exceeded their capital. Yet they weathered that situation without talk of government help," he said. The two mortgage giants are, however, subject to the same tight capital market as everyone else.

"Merrill Lynch recently issued a statement that the Fannie Mae and Freddie Mac problems are causing liquidity problems for U.S. banks. Unfortunately, that statement is misleading," Sanders said. "There has been a liquidity problem facing the U.S. since the subprime meltdown began. Fannie Mae and Freddie Mac are facing the same 'credit fears' in terms of raising capital that other financial institutions and corporations are facing."

What if …

After reports called the downfall of Fannie Mae and Freddie Mac imminent and investors fled, the Fed and the Treasury took action, meeting over that weekend to announce that they would not let the mortgage giants fail. The Fed opened the discount window to offer much-needed liquidity to the companies while Treasury Secretary Henry Paulson went to Congress to ask for authorization to buy shares of Fannie and Freddie if it were necessary.

"For decades Fannie Mae and Freddie Mac have had an implicit government guarantee," Kaufman said. "Last week, given the Fed and Treasury's moves, the guarantee became explicit." That guarantee of government backing seemed to allay fears on Wall Street and Fannie Mae and Freddie Mac's share prices rebounded. But will the Fed and Treasury's vote of confidence in Fannie Mae and Freddie Mac be sufficient to keep the companies stable?

Will their words have to be backed up with actions? "It depends," Kaufman said. Any number of events could lead to a decline in investor confidence and a further tightening of credit markets. Then the government would perhaps be motivated to act, Kaufman said. "If, for example, a major investment bank — like Lehman Brothers — fails, or another lender — like Washington Mutual — follows IndyMac's collapse, confidence would fall and the government might have to act," he said.

There doesn't seem to be any sign of recovery in housing prices, Kaufman added, and that's another factor keeping confidence weak. Perhaps the greatest potential danger, though, is the high level of international U.S. debt holdings. "Fannie Mae and Freddie Mac's debt holdings are widely spread internationally," Kaufman said. "An international panic would potentially force government action — at least an infusion of liquidity from the Fed."

That's why, Kaufman said, Treasury Secretary Paulson spoke so aggressively about Fannie Mae and Freddie Mac's soundness. "Paulson spoke so vigorously to reassure international — as well as domestic — debt holders." While a massive international dumping of U.S. debt holdings would be disastrous, Kaufman sees no sign of that happening. And while the high level of international investment might be a danger now, it's been a large source of the U.S. market's strength.

"The fact is that the large amount of dollar holdings abroad has provided enormous liquidity for dollar-based debt," said Kaufman. "A loss of international confidence would lead to a tremendous decrease in debt liquidity. That's why an international panic has worse implications than a domestic panic."

Nevertheless, Kaufman doesn't think that the Treasury will need to bail out Fannie Mae or Freddie Mac. "Fannie Mae and Freddie Mac will survive this market without explicit government action though the statements made by the Treasury and Fed were important," he said.

Moving forward

The fact that the collapse of Fannie Mae and Freddie Mac would be so disastrous points to their important role in the U.S. economy. "Fannie Mae and Freddie Mac serve an important role in the U.S. and global economies by providing stability to the U.S. housing and mortgage markets through their mortgage-backed security and guaranty programs. In fact, Fannie Mae and Freddie Mac have been the shining beacon of stability in U.S. mortgage markets since the housing/mortgage crisis began," Sanders said.

Kaufman agreed. "Fannie Mae and Freddie Mac own or guarantee over $5 trillion in debt. They've made the mortgage market liquid and mortgage rates reasonable. They play a vital role in the economy." But while Kaufman and Sanders resoundingly agree on the vital role that Fannie Mae and Freddie Mac play in the nation's economy, they disagree markedly when it comes to moving forward. Kaufman advocates for an increase in government oversight right away.

"Fannie Mae's CEO Daniel Mudd has said that if the Treasury's guarantees are invoked then there will be more government oversight of the companies' operations. But I think that additional oversight is important anyway — at least in terms of executive compensation and other management decisions," Kaufman said. In the future — once the current mortgage crisis and credit crunch has passed — Kaufman thinks that Fannie Mae and Freddie Mac deserve a much more thorough re-examination.

"At some point down the road — if it's ever feasible — we should explore the possibility of severing all ties between the government and Fannie Mae and Freddie Mac — to remove even the implicit guarantee of government backing." Kaufman added that he doesn't know if that will ever be feasible. "We should have done that a decade ago when the time was right," he said. "At the very least, increased government regulation of Fannie Mae and Freddie Mac's operations is absolutely necessary right now."

Sanders strongly disagrees. "Not all change is good and often it is bad," he said. "Fannie Mae and Freddie Mac have charters that are sensible and increasing regulations or changing their charters is about the last thing this economy needs. We need stability, not change in terms of Fannie Mae and Freddie Mac."

Perhaps as an effort to head off criticism that it's mismanaged, Freddie Mac registered last week with the Securities and Exchange Commission, which requires that the company periodically file financial disclosure and make its annual, quarterly, and current financial reports available to the public.

Certainly Fannie Mae and Freddie Mac are too important in the U.S. economy to fail. But Kaufman and Sanders don't believe that they will even need to tap government guarantees to weather the financial storm. The numbers — in terms of delinquency rates, at least — support that view.

Bottom Line:

• Fannie Mae and Freddie Mac, contrary to popular media reports, are not on the verge of collapse.
• Default rates — measured by the number of seriously delinquent loans — are 0.81 percent at Freddie Mac and 1.15 percent at Fannie Mae — lower than the market-wide rate of 1.47 percent for prime mortgages, 8.35 percent for Alt-A mortgages, and 20.74 percent for subprime mortgages.
• Fannie Mae and Freddie Mac aren't the cause of liquidity problems in the U.S. financial markets, but rather are facing the same tight capital market — precipitated by the subprime meltdown — that everyone is facing.
• Any number of events could lead to a decline in investor confidence and a further tightening of credit markets that could motivate the government to act on its now-explicit guarantee of the mortgage giants. But W. P. Carey finance professors Kaufman and Sanders don't think that the Treasury will need to bail out Fannie Mae or Freddie Mac.
• Kaufman and Sanders disagree on how to move forward. Kaufman advocates for an increase in government oversight right away while Sanders thinks the government should leave Fannie Mae and Freddie Mac as they are.

Finance Faculty