America’s government-backed mortgage facilitators are heading for a fall, but they are too big and important to be allowed to fail. Is this America’s Northern Rock? Tim Bennett reports
Who are Freddie Mac and Fannie Mae?
In a nutshell, mortgage facilitators set up to support the American housing market. Commercial lenders write mortgages and can subsequently sell them to, or have them underwritten by, either Fannie or Freddie. They then use the cash raised to create further mortgages. This emboldens lenders to service borrowers who might normally struggle to raise a home loan and also typically saves those borrowers between 0.25% and 0.5% on their mortgage rate.
On top of that, the two companies also package up the mortgages they buy and resell them as mortgage-backed securities (MBS) to institutions looking for a relatively safe place to invest cash. Freddie and Fannie themselves raise their finance from a mixture of bond and share sales, just like any other public company, except that their unique status – both carry the special badge, “Government Sponsored Enterprise” (GSE) – denotes the implied backing of the US government, something that enables them to borrow cheaply.
Where did they come from?
Fannie, initially a government agency established under Franklin D Roosevelt’s presidency back in 1938, is the elder and larger sister of Freddie, which arrived in 1970. The two are technically rivals, each a public, listed company trading on the New York Stock Exchange (NYSE:FNM and NYSE:FRE). However, they were set up with identical charters and handed the same mandate from the US Congress, summarised by the Washington Post as “bringing stability to the US mortgage market” – something that their support of the mortgage market has long done.
Fannie was spawned to solve the lending crunch created by the 1930s Great Depression, whereas Freddie was tasked later with ironing out the huge regional variations in interest rates and lending criteria that prevented many Americans from clambering onto the housing ladder. Today, says Barron’s, they guarantee or own over half the US mortgage market, worth around $11trn.
Why are they in the news?
They are both in big trouble. Fannie’s share price is down around 60% since the credit crunch struck in August, while Freddie’s has undergone what The Washington Times calls a “stunning decline”, by halving in under a month. Once considered economic bastions, the pair managed to lose $6.1bn in the fourth quarter of 2007 alone and Freddie has been forced to raise $14bn in bond sales this year.
In short, investors have woken up to the fact that both are now being badly battered by the credit crunch. As a result, the difference, or “spread”, between the rate they pay to investors on their own bonds and safer US Treasuries has shot up to a 20-year high – despite their implicit government guarantee.
How are they regulated?
Uniquely. A 1992 act created a special regulatory framework for GSEs, whereby the Government Department of Housing and Urban Development oversees their “housing mission” and capital adequacy separately from other financial institutions. Between 2005 and 2008 they both had their affordable housing remits hugely expanded to cover swathes of previously ineligible low-income, high-risk borrowers.
The result, says Barron’s, was a “speculative foray into subprime and Alt-A loans (where there is little or no proof of income)”, leaving them with balance sheets “larded with soft assets and understated liabilities”. In spite of this, Freddie and Fannie enjoy less stringent capital adequacy (or “rainy day”) requirements than other US lenders and give away less information about what they are up to because full SEC disclosure requirements don’t apply.
How bad could it get?
No one knows. Taking just Fannie Mae, Barron’s estimates that even if it only suffers “conservative” default rates of 40% on it’s $133bn subprime loan book, 12.5% on Alt-A mortgages and just 4% on its remaining $2trn prime home loans, future credit losses could exceed $50bn. Last August it was unthinkable that either of these two could ever actually go bust – but now, should they have to take any more big hits (market valuations for all mortgage-backed debt are in freefall), it is technically possible, says Barron’s. The two raised $13bn from share issues last year, but that trick won’t be repeated in these markets.
That said, the prevailing view remains that they are too big to fail, not just because of their core role in the mortgage markets, but because crucial trade partners – such as China and Japan – are big investors. Expect to see a government bailout that will make the sums spent in the UK on Northern Rock look like chicken feed.
The new age of “upside-down” mortgages
Up until the credit crunch struck, homebuyers and lenders – both here and in the US – agreed huge mortgages based on the euphoric assumption that house prices could never fall, leaving the borrower with an asset worth comfortably more than the mortgage – a joyous era of “positive equity”. However, according to Lewrockwell.com, if US house prices fall another 10% nationally, a minimum of 20 million households – or an estimated 43% of all mortgaged US property owners – will be stuck with “upside down” mortgages exceeding the value of their homes.
What to do? Many will sell up, but that already takes on average almost a year. Others will simply sit tight. With an average foreclosure costing $50,000, and lenders ill-prepared for the deluge of mortgage defaults, many struggling borrowers will opt out of mortgage payments and “live rent-free” instead.