The Fannie-Freddie Takeover: A Latter-Day RTC

Listen to a podcast about the Treasury plan for Fannie Mae and Freddie Mac

• The Treasury’s takeover of Fannie and Freddie was a reasonable response to the GSEs’ mounting financial problems.

• Although Fannie and Freddie shareholders will lose, and the move will cost U.S. taxpayers tens of billions of dollars, the housing market will receive an important boost via lower mortgage rates and more available mortgage credit.

• The effective nationalization of the nation’s mortgage market will not forestall further house price declines, but it raises the odds that those declines will not exceed 5% to 10% of current levels.

• The takeover will complicate matters for the next president, who must figure out how to gracefully reprivatize these institutions in some form.

• But it significantly reduces the near-term threat to the housing market, financial system and broader economy.

The Treasury Department’s historic takeover of Fannie Mae and Freddie Mac is a necessary move that will provide an important boost to the flagging housing market, and by extension to the broader financial system and economy. The two government-sponsored enterprises’ finances were apparently worse than their managers had let on, and were deteriorating rapidly. Although policymakers will have their hands full for years deciding what to do with these institutions, the immediate impact of the takeover will be to lower mortgage rates and increase the availability of mortgage credit.

The Treasury’s principal actions:

• Putting Fannie Mae and Freddie Mac under the conservatorship of their newly formed regulator, the Federal Housing Finance Agency.
• Sufficiently recapitalizing the institutions so they can expand their support of the housing market.
• Establishing a new secured lending facility to provide liquidity to Fannie, Freddie, and the Federal Home Loan Banks.
• Investing in mortgage-backed securities issued by Fannie and Freddie.

Losers and winners

The biggest losers in the Treasury takeover are Fannie and Freddie shareholders. Although their stock certificates weren’t literally shredded, as would have been the case had the institutions been put into receivership, common shareholders will likely lose everything and preferred shareholders are sure to take a massive financial hit. This will complicate matters for other financial institutions, including many small and midsized commercial banks that hold Fannie and Freddie preferred stock as part of their capital base.

The move will also cost taxpayers, though how much is unclear and depends on many things, including the size of the capital holes in Fannie’s and Freddie’s balance sheets. This in turn will ultimately be determined by the severity of the housing downturn and foreclosure crisis. It would not be surprising if taxpayers were ultimately asked to ante up $100 billion or so to recapitalize Fannie and Freddie. Those costs could eventually be recouped, however, through fees, dividend payments, and whatever is raised when the firms are reprivatized in some form.

The biggest winners are Fannie’s and Freddie’s debt holders. Indeed, it was the mounting evidence that central banks, sovereign wealth funds, and other global investors were growing reluctant to invest in the debt that was the catalyst for the Treasury Department’s actions. Fannie and Freddie debt is now effectively U.S. Treasury debt, ensuring that debt holders will remain whole.

Homebuyers and homeowners looking to refinance will also benefit, because mortgage rates will decline. The Freddie Mac 30-year fixed commitment rate stood at 6.35% last week, almost 265 basis points above 10-year Treasury yields. This was the widest yield spread since the early 1980s, and it demonstrated the degree of global investor angst. The average spread over the past quarter-century has been 170 basis points. If the yield spread simply narrows to its long-run average, fixed mortgage rates should fall to well below 6%, even assuming that Treasury yields rise a bit in response to the GSE takeover. This will provide an important boost to the extraordinarily sensitive housing market.

Recapitalizing Fannie and Freddie will also increase the flow of mortgage credit. When Congress passed a fiscal stimulus package earlier this year, it granted the GSEs authority to make much bigger loans than previously allowed, expecting they would make those bigger loans in the nation’s most distressed housing markets such as California and Florida. Unfortunately, for various reasons including a lack of capital, Fannie and Freddie were unable to step up. Now, with the Treasury infusing them with capital, they will have the financial muscle to do what Congress originally intended.

The Treasury Department’s actions seem well-timed. Global equity and credit markets were slumping again in large part because of Fannie and Freddie’s travails. Global stock prices fell some 5% last week, the sharpest weekly decline since January, and the Dow Jones Industrial Average is back near its cyclical low. Treasury’s move will not end concerns about global growth, but it will eliminate the threat posed by the potential failure of two of the globe’s largest financial institutions. The political timing also appears on mark, coming just after the Democrat and Republican conventions but before presidential electioneering reaches a fever pitch.

The exit strategy

There are downsides to the Treasury’s actions. No one thinks the federal government should be effectively the nation’s sole mortgage lender for very long, but reprivatizing Fannie and Freddie will not be easy. However they are reincarnated, they will surely not be backed by the government and so will no longer subsidize the housing market via lower mortgage rates. They will also not focus on providing mortgage credit to disadvantaged demographic groups with lower homeownership rates. Although this is not a bad thing in principle, it will make it hard for Congress to find the political will to set the firms free. The Treasury plan recognizes this by requiring Fannie and Freddie to shrink their balance sheets by 10% a year beginning early in the next decade, hoping that smaller institutions will be easier for Congress to privatize. It will be tough, nonetheless.

Nationalization of Fannie Mae and Freddie Mac may not have been the best policy step—that depends on how bad their balance sheets really are—but it is a very reasonable one. With this move, the U.S. government is using its own Aaa balance sheet to shore up the balance sheet of the global financial system. This is not unlike what was done in the early 1990s, when the Resolution Trust Corp. was established to nationalize the nation’s teetering savings & loans. The RTC worked effectively then to stem that financial crisis, and the nationalization of Fannie and Freddie will surely work now. Other financial shoes are likely yet to fall, but when the history of this period is written, it will show that the Treasury’s actions marked the beginning of the end of the subprime financial shock.