Thursday, 12 September 2013

Back from the dead: Here come Fannie and Freddie

In a series of texts on the 5 year "anniversary" of the financial crisis (see among others the Economist, Financial Times, Wall Street Journal, New York TimesBloomberg), many commentators and economists are reminiscing on the panic that surrounded the world of finance at the time following the infamous bankruptcy of Lehman Brothers. More importantly they are all drawing lessons for today, evaluating how far we have gone from the crash and how much we have learned. I was planning on making a few of my own contributions to mark the troublesome events from the fourth quarter of 2008, and I will start by looking at where Fannie Mae and Freddie Mac, those two "evil" Congress-led, HUD goal-obliging, government-sponsored enterprises are today. Financial Times has the numbers stating that 5 years after their $189bn government bailout Fannie and Freddie are actually quite profitable. 

As the US housing market is recovering from its arguably worst slump in history, many cities are experiencing large increases of housing prices which are significantly improving the health of domestic financial institutions, in particular the mortgage giants Fannie Mae and Freddie Mac.

The pivotal role in the housing bubble

To reminiscent, the role these two government sponsored enterprises had in the crisis was somewhat pivotal. I covered this in my paper on the financial crisis published two years ago. Basically, Fannie and Freddie had a distinguished goal of purchasing mortgage loans from banks on the sub-prime mortgage market. They then either kept these loans as a monthly source of revenue or decided to repackage them into a big, allegedly risk diversified security know as a mortgage-backed security (MBS) and sold it on the market. On the other side of the bargain were banks (both commercial and investment) which filled up their balance sheets with these allegedly zero-risk securities, all in accordance with the so called recourse rule which encouraged private banks to purchase MBSs in order to diversify their risk. A legitimate goal, but the only problem was that MBSs were not a zero-risk asset (no asset is), just like Greek sovereign debt in reality wasn't a zero-risk AAA rated asset. This didn't stop the regulators to encourage the purchases and creation of such assets, nor did it stop the banks from buying them. And why should it? They were all under the impression that they were doing a beneficial thing - the regulators thought they were decreasing risk, while the banks were earning a great profit on such low cost assets. The problem was the artificial demand created on the market for MBSs. Since the banks saw them as a profitable opportunity, and the regulators encouraged this, there was an ongoing pressure for creating more and more of such assets, thus increasing the demand as well as their price. And who created these assets? Our heroes: Fannie and Freddie. They are the ones that used the huge amount of sub-prime loans at their disposal to repackage them into giant MBSs. 

But why, one might ask. Why did Fannie and Freddie have all these sub-prime loans? At the onset of the crisis, Fannie and Freddie have acquired half of all low and moderate income mortgage loans (these are referred to as sub-prime loans), according to the Housing and Urban Department (HUD). However it was the HUD whose target goals Fannie and Freddie were following. A report from the HUD clearly states that F&F had to achieve a joint presence on all of the sub-prime mortgage loan markets at over 50%. And they did this. They have accomplished their goals. The problem was that while doing so they initiated a huge negative spiral of artificial demand for MBSs, which was further fueled by regulator rules such as the aforementioned recourse rule, and faulty risk estimates coming from the rating agencies. 

Finally, the central argument against the very existence of F&F came from none other than Alan Greenspan, Fed Chairman at the time, a few years before the crisis had started. In addition to his warnings on their riskiness, his argument was that GSEs haven't even been able to decrease interest rates for middle-class home buyers, the central justification they always gave for their existence.

The epilogue was a $189bn bailout by the Treasury, entering them in the category of "too big to fail". 

Five years later

Source: FT
Five years later, Fannie and Freddie went from hanging on a thread of bankruptcy and a potentially huge burden on US taxpayers in the years to come, to bouncing back as source of revenues for the Treasury, reporting a profit of $10bn for Fannie and $5bn for Freddie. Fannie was able to return a total of $105.3bn in dividends to the taxpayers, falling only a bit short of the $117bn of bailout funds given to it. In total the GSEs have jointly accumulated $146.2bn that they have returned to the Treasury, being only a few quarters away from repaying the full $189.4bn bailout bill. The reason for their extraordinary good results was primarily an increase in house prices on the recovering US housing market which consequently reduced their loss reserves.

Those investors brave enough to buy into Fannie and Freddie's preferred stocks in 2009 are relishing at this news. Their risk has paid off. They were betting that the housing market will eventually regain strength and thus enable the GSEs to start rolling profits once more. The justification of such a strategy was that Fannie and Freddie were given far more bailout funds than needed to cover their short-term losses. Apparently, they were right. 

Even though by the end of 2008, Fannie and Freddie certainly were in desperate need for liquidity, the total amount of money they needed was based on underestimating the relatively pacey recovery of the housing market. This is easy to say today, but with the overall panic at the time the Treasury apparently didn't want to take any chances.

However the investors aren't all that happy since an decision has been made last year by the Treasury where all new profits are going back to the taxpayers in the form of dividend payments. This wasn't part of the deal in the 2008 bailout, and is hurting the investors. Basically, the Treasury has decided to sweep in all future profits that the GSEs have made. However since the profits are being denoted as dividends, not repayments, this still means that Fannie and Freddie haven't really payed off the debt. In legal terms that is. Which is why the investors are worried, and lawsuits are underway. After all, their argument is that since they are the shareholders of the preferred stocks, they have the rightful claim over the profits of the GSEs. 

This isn't the only thing worrying the investors. There is ample desire for reforming and even abolishing the GSEs. President Obama has given support to replacing the agencies with a new one that has a much more limited role on the market and that will hopefully transfer some of the risk back to the private sector. However with the recent numbers and the recovery on the housing market, the plea for reforms will probably end up with only a few changes, and will hardly be a fully pledged overhaul as many were announcing. 

Life is still uncertain for Fannie and Freddie. After a turbulent period where they went from being accused as the sole culprit for the housing bubble burst, and after being bailed out by the Treasury, they managed to become the net contributors to the budget, having yet to survive attempts of reform. They seem to be riding out the storm pretty well at the moment due to their good numbers and a favorable market, but the question is how long this will last, and even more importantly how much more sub-prime mortgages can they acquire in the mean time. 

3 comments:

  1. A great explanation on Fanny and Freddie's role in the crisis. Thanks for this

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  2. I wonder what would it be like if all the bailout recepients would be as efficient in paying back the taxpayers as Fannie and Freddie did. I'm thinking RBS for example.
    As for their existance, does the fact that they've paid off the debt (or will do it soon enough) justify their further presence on the housing market?

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    1. Yes and no. Yes - they've managed to pay it off, no - their existence on the market was questionable from the very beginning.

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