Fannie Mae and Freddie Mac
Refinance

Bailout Required for Fannie and Freddie After All

Sept 17, 2008 - All hopes were dashed that misguided GSE (Government Sponsored Enterprise) giants Fannie Mae and Freddie Mac would be able to work their way out of trouble as the pair were unable to raise sufficient capital on their own to withstand accumulating losses. Financial pressure mounted as investors lost confidence in the pair, reflected by their free falling stock price, making it all but impossible for them to raise the capital necessary to stay afloat. Treasury Secretary Paulson was left with few alternatives after attempting to calm the international jitters of foreign governments holding substantial quantities of Fannie's and Freddie's debt. The GSEs were running out of options and the decision to take over the pair was ultimately made by Paulson. Shockingly, the combined debt of both GSEs actually exceeds that of the entire privately held U.S. national debt and although the enormous potential liabilities of both Fannie and Freddie could end up costing U.S. taxpayers billions, the financial disaster which would have unfolded if they been left to fail, could have been far more devastating. Though Freddie Mac's financial condition is more dire than that of Fannie Mae's, it was necessary to take over both entities in order to maintain the necessary level playing field between the two mortgage giants. Both GSEs reopened their doors on September 8, 2008 under the authority of the newly created Federal Housing Finance Agency (FHFA) which supplanted the Office of Federal Housing Enterprise Oversight (OFHEO), the GSE's former overseer under the Department of Housing and Urban Development (HUD). The GSEs are both under the conservatorship of FHFA, in a process comparable to that of a Chapter 11 bankruptcy filing, where reorganization rather than liquidation of assets takes place.

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The two GSEs were originally created to provide liquidity to the housing market by purchasing mortgages from various types of mortgage lenders such as commercial banks, saving banks and mortgage bankers. The mortgages which the GSEs acquired were then re-packaged and used as the underlying collateral for bonds called mortgage-backed securities (MBS) and the buyers or investors of these securities were in turn guaranteed by the GSEs against default. A dangerous and real perception existed amongst investors that although the U.S. government did not explicitly back the GSEs the way it does Treasuries, they did so implicitly because the two were created by government charter. This perception gave the GSEs the unfair advantage of being able to borrow money as a private corporation, at rates similar to that of a U.S. government entity. The critical question which begs asking is why the GSEs status was necessary to back the safety of mortgages which were already inherently safe to begin with, reflected in the sound guidelines and safe practices that had long been the standard of Fannie Mae and Freddie Mac?

Their troubles likely began when the two GSE giants started using the cheap financing sources, available to them as a result of their implicit Treasury backing, to invest in mortgage securities generated by outside (and clearly much riskier) sources with the objective of maximizing private shareholder returns. Of course it seems patently unfair that a taxpayer implied backstop could be used to generate private profits for the GSE's shareholders, yet this is what occurred and may be reflective of why Freddie was in deeper trouble than Fannie. Though the outside securities they purchased may have been AAA rated, this tragically misapplied rating was given to too many untested high-risk securities in the era of sub-prime lending like the creative CDOs which are at the core of the mortgage-backed securities debacle. Let's hope that whatever form the GSEs take in the future, that the unfair dichotomy where profits are handed over to private shareholders and the bill for losses is unjustly assigned to the taxpayers will have no part in it. Let's also hope that the new overseer of the GSEs, the Federal Housing Finance Agency (FHFA), is able to do a far better job, as both watchdog and guardian of the entities, than the previous overseer, the Office of Federal Housing Enterprise Oversight (OFHEO).

Nancy Osborne, ERATE.com Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.