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 January 2008 No Win Situation Freddie Mac and Fannie Mae are Damned if They Do and Damned if They Don't
Two of the oddest victims are the government's own creations, Freddie Mac and Fannie Mae. Charged with helping to make home ownership affordable to low-income borrowers, these institutions are generally viewed as security issuers rather than security owners. Nevertheless, they've been swept up in the subprime crisis right along with money center banks and overly aggressive investors. Perhaps the biggest difference is that unlike most others sullied by subprime loans, Fannie and Freddie had little choice but to participate. Even more remarkably, some have argued they should have been involved to an even greater extent. Sadly, they may be correct.
Not So Smooth This task is typically accomplished by Fannie and Freddie serving as ready buyers for "conforming" mortgages originated by banks and lending institutions. This encourages the lenders to extend credit to smaller borrowers since they can easily offload the debt to Fannie and Freddie.
In order to buy additional loans, Fannie and Freddie package up those previously purchased and sell them to investors as agency bonds. The underlying mortgages provide the income stream and return of principal for investors. The U.S. government provides an implicit backing for the debt although it's never been called upon in this capacity. Profits from Freddie and Fannie's purchases and sales go to their shareholders, not the government. This has always been a point of contention in Congress. Fannie and Freddie both suffered accounting woes in the earlier part of this decade. Fannie used derivative securities to hedge against interest rate fluctuations in the mortgages held in its own portfolio. While the use of derivatives was not itself illegal, the fact that Fannie did not mark them to market in their financial reporting was questionable. Fannie's management argued that the derivatives were held for hedging purposes and not investment. As such under generally accepted accounting practices (GAAP) it wasn't necessary to mark them to market. Congress disagreed, and Fannie was forced to restate prior quarters' results including derivative losses. Freddie didn't use derivatives to the same extent as Fannie, but instead was found to have "smoothed" quarterly earnings. This was a practice followed by many companies in the late 1990s and earlier part of this decade. As analysts and investors put greater and greater weight on quarterly earnings, firms felt pressured to meet or exceed short-term estimates. More importantly, it was necessary to never miss expectations because that almost certainly led to a sharp selloffs. Like many others in the period, Freddie was accused of smoothing reported earnings by holding back profits in good quarters to use as a "rainy day" fund to augment those of poorer quarters. Although management denied it -- right to the very end -- the SEC found otherwise. Like Fannie, Freddie was also forced to restate quarterly earnings covering a number of quarters.
Reined In Freddie and Fannie were always a touchy subject for the politicians given the implicit government backing of a publicly owned company. Getting tough with the agencies had a certain populist appeal.
Congress' solution was to severely limit the amount of loans Freddie and Fannie could hold on their own books. After all the agencies' goal is to help extend loans to lower income borrowers by maintaining a stable market, not to profit their own shareholders via gains on their own portfolios. As a result, they were forced to significantly trim their portfolios while devoting more capital to low-income financing. The portfolio reductions had to occur over time so as not to disrupt the market with a flood of sales. As expected, quarterly earnings growth not only slowed, it became more volatile. Congress had spoken.
Primed for Subprime When the credit crisis finally came to ahead in August, subprime mortgages were the hardest hit. Those that had been rated AAA earlier in the year quickly fell to junk status. Some couldn't even be priced because there were no willing buyers to take the other side of the trade. Freddie and Fannie insisted (and still insist) that they didn't hold the riskiest subprime securities, known as collateralized debt obligations (CDOs), yet that still didn't shield their subprime holdings from major write-downs. In late November, Freddie reported holding $105 billion subprime mortgage loans, Fannie is thought to have a lesser amount. As these loans have declined in value, so has the agencies' capital. Freddie wrote down just over $2 billion but it's speculated it might take another $5 billion to finally clear the air. Fannie is in better shape, but both were forced to raise capital the sale of preferred shares -- $7 billion for Fannie and $6 billion for Freddie. Both trimmed their dividends, too, by 30% and 50%, respectively. As a result, these are not your grandfather's agencies. Until Congress stepped in, they were viewed as safe (although unexciting) investments with secure dividend streams. Not anymore. But here's where it gets interesting: In light of their declining portfolio values and constrained capital, Freddie and Fannie haven't been able to help out those low-income homeowners as much as some Congressmen would prefer. Not only that, without this backstop, lenders have tightened credit requirements focusing on higher quality loans that can be sold to Freddie and Fannie. As a result, some in Congress -- the very people who tied the agencies' hands -- have called upon them to do more. On the other hand, one could argue they've already done too much. The foray into subprime loans was an effort to encourage lending at that level. Without the mandate to extend services there, some of the write-downs and capital losses could have been averted. Ironically, others in Washington are blaming Freddie and Fannie for exacerbating the problem through their purchase of subprime securities. They charge that by entering the market, the agencies actually added fuel to the already overheated process. A few things are certain. First, Freddie and Fannie can't win. No matter what they do, someone with no direct interest or tie to the market will be dissatisfied. You can't please everyone in Washington at the same time. Secondly, and even more importantly, the problems at Freddie and Fannie (and quite possibly those in the subprime market as a whole) weren't helped by Congress' attempt at regulation. Left alone, the two agencies would have more capital on the books and would be in a better position to help the ailing mortgage market. As it now stands, they can do neither. Search this site! Just enter you key word or words:
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S IT WINDS ON, THE subprime loan meltdown continues to claim more and more victims. First it was the lenders caught flat-footed by the sudden lack of liquidity. Then it was investors who rudely learned why their investments were considered high risk. Throughout the process borrowers who should never have entered such an arrangement with any realistic belief of repayment have seen their homes jeopardized when their loans reset at significantly higher rates.
