Fannie Mae and Freddie Mac — Androgynous Financiers

The ambiguous identification of government-sponsored entities (GSEs) Fannie Mae and Freddie Mac with the government and the private sector has taken on new twists. Loose lips, general uncertainty, and sheer panic have contributed to a crash in their stock prices and raised questions about their previously-sterling credit standing.

The Non-guarantee

Fannie and Freddie are required by their government charters to inform investors that their securities are not backed by the government. Investors, however, have generally treated their debts and other obligations as implicitly government-guaranteed, allowing them to borrow at rates only slightly higher than Treasury bond yields.

In recent years, the Treasury Department and the Federal Reserve have sought to undermine that confidence. For example, in a speech in 2004, then-Secretary John Snow said:

"GSEs are able to borrow at rates that are lower than their other financial competitors, other financial institutions, because they are perceived by many in the marketplace to have a relationship with the government, they are perceived to have a government guarantee."...

"We don't believe in a 'too big to fail' doctrine, but the reality is that the market treats the paper as if the government is backing it. We strongly resist that notion.

"You know that there is that perception. And it's not a healthy perception and we need to disabuse people of that perception. Investments in Fannie and Freddie are uninsured investments."

As recently as March of this year, Fed Chairman Bernanke said, "Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline."

No protection may be available for the GSEs' shareholders, but it will probably now be demonstrated that their creditors were right to ignore the Treasury and Fed trash talk. While there has been a debate about whether Bear Stearns should have been allowed to default, the danger to the financial system and the economy is vastly greater in this instance. Indeed, the interest rate premium on GSE debt over Treasury bonds actually narrowed last week, when it was recognized how unthinkable it would be to not honor the GSE obligations.


The GSEs provide funds for mortgage lending in two ways. They buy mortgages or mortgage-backed securities (MBS) to hold as portfolio investments, financed by issuing corporate bonds, and they provide guarantees against default for MBS that are sold to other investors (or to themselves). Much of the criticism of the GSEs by the Fed, Treasury, and others related to their increased reliance on portfolio purchases rather than guarantees. It was argued, with considerable justification, that holding mortgage assets in portfolio exposed the GSEs to greater risks. It was further argued that they did so to increase profits without lowering borrowing costs for home buyers. In the course of those arguments it was invariably stated that interest rate risk (from portfolio activity) was severe, while credit risk (present with both purchases and guarantees) was manageable and "not a serious problem." The current difficulties, however, are primarily the result of credit risk.

Some of those credit risk problems reflect regulatory requirements. Fannie and Freddie are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO) with regard to safety and soundness (although that regulatory responsibility may be shifted to a new agency under pending legislation). They are also subject to regulation by HUD under mandates to serve low- and moderate-income households and neighborhoods. As originators and investors with more energy than brains expanded (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. The GSEs didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.

Raising Capital

On February 13, President Bush signed the Economic Stimulus Act of 2008, which included a temporary increase in the maximum loan eligible for sale to Fannie and Freddie. With that new authority, and with other sources of mortgage credit sidelined, the housing industry, Congress, and the Administration expected Fannie and Freddie to expand their activities. To do so, and to offset losses from write-downs, they would have to increase their capital bases. The regulatory capital requirements to support MBS guarantees are less than those to support portfolio assets, so they can facilitate more mortgage lending by shifting to that line of business, but they still require more capital to continue to fill the void left by defunct or hobbled private conduits.

Freddie Mac CEO Richard Syron, however, was under the impression that he was running a private-sector firm on behalf of shareholders. On March 12, he told a meeting of Wall Street analysts that Freddie didn't plan to raise additional capital and thereby dilute the value of the stock, which had already fallen by more than half. That was not well-received in Washington. A week later, Syron joined CEO Mudd of Fannie Mae and OFHEO Director Lockhart to announce a planned expansion.

OFHEO increased the amount that the GSE could invest, relative to their capital bases, in part based on the promises to raise additional capital. Subsequently, Fannie--the more politically-attuned sibling--sold some common and preferred shares (less than OFHEO wanted), but Freddie only has said it will raise capital "in the near future."

The quasi-public, quasi-private housing GSEs had come to be regarded by many as arrogant, greedy, opaque, reckless, and unnecesary. In current circumstances, "unnecessary", at least, must be dropped from that list.

July 12, 2008 -

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