Fannie, Freddie, Folly

Why the two mortgage giants can’t be allowed to fail.

Read more about Wall Street’s ongoing crisis.

A foreclosure sign sits in front of a home

Fannie Mae and Freddie Mac, the two government-sponsored enterprises that play an important role in the mortgage market, are tanking today. (Here’s the very sad five-year chart.) Investors are concerned that the companies, after racking up big losses (with much more red ink to come), might have difficulty raising needed capital. Between them, they have on their books or stand behind about $5 trillion in mortgages, including plenty of junk. As Charles Duhigg reported earlier this year in the New York Times, “By the end of last year, the companies had guaranteed or invested in $717 billion of subprime and Alt-A loans, up from almost none in 2000.”

There have been reports that the Bush administration is considering plans to place the two companies into receivership. Should Fannie and Freddie fail, there’s no question that executives and policymakers should blame themselves for poor decisions made over the last several years. But Fannie and Freddie’s current travails can also be ascribed to the more recent screw-ups of the big investment banks.

The troubles of the private investment sector will make it much harder to rescue Fannie and Freddie. For much of the past year, the CEOs of the nation’s iconic financial firms have reported unexpected losses, declared their troubles over, and raised money from investors (frequently foreign ones) to make up for those losses—only to report fresh losses a few months later. Lehman Brothers CEO Richard Fuld boldly proclaimed on April 15, “The worst is behind us.” In the three months since then, Lehman reported further losses and its stock has lost half of its value. Last year, we noted the challenges facing investors and institutions that tried to catch falling knives in the financial sector. Last September, Joseph Lewis, one of Britain’s wealthiest men, spent $860 million on a 7 percent stake in Bear Stearns, paying an average of about $107 per share, according to the Wall Street Journal. Bear was sold to J.P. Morgan in March for $10 per share. As saviors were quickly turned into chumps, outside investors began demanding better terms—i.e., buying stocklike securities that paid interest rates or buying shares at a discount to the market price. But even these savvy investors have been burned. Last November, to take one example, Citigroup sold interest-bearing convertible securities, which convert into Citi shares between 2010 and 2011 at prices ranging from $31.83 to $37.24 per share, to the Abu Dhabi Investment Authority. Since then, Citigroup’s stock has fallen by more than half of its original value to less than $17. Sovereign wealth funds that bought into offerings from companies like Merrill Lynch have suffered the same fate.

When asked to comment on such deals, Treasury Secretary Henry Paulson would always try to make lemonade out of the lemons, noting that these dilutive capital raisings are a sign of great faith by foreigners in America. Now, however, institutional investors are likely to think twice about putting billions of dollars to work in U.S. financial firms, and especially into Fannie Mae and Freddie Mac. The concern—and skepticism—over the ability of the two firms to raise fresh capital on anything resembling decent terms is part of what’s behind the abrupt fall in their stocks. As of yesterday’s close, Fannie Mae had a market capitalization of about $13 billion and Freddie Mac was worth about $5 billion. Given the massive size of their portfolios and the potential for losses, it’s clear they will need to raise sums that may equal or dwarf their current market capitalizations. Given the firms’ distressed state, buyers would certainly demand a discount. As J.P. Morgan CEO Jamie Dimon said in his now-famous formulation about Bear Stearns,“Buying a house is not the same as buying a house on fire.” Fannie Mae and Freddie Mac are houses on fire. And this mentality leads to a vicious cycle: Investors jump ship because they fear dilution, and the more the stock slips, the more dilute capital-raising becomes. At the close of trading Friday, Fannie Mae’s market capitalization had dropped to about $10 billion. In addition, potential foreign investors would face thorny political issues. If Americans are upset that a Belgian company wants to buy Anheuser-Busch, just imagine the uproar if a Persian Gulf emirate took a huge position in Fannie Mae and hence stood to benefit from an implicit taxpayer subsidy.

Treasury Secretary Henry Paulson today tried to scupper talk of a bailout. “Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission.” Should Washington intervene and explicitly do what has been assumed all along—backing Fannie Mae and Freddie Mac’s debt—critics on the left will correctly claim that it’s another example of privatizing profit and socializing risk. Critics on the right will argue that the government has effectively nationalized the mortgage industry.

But guess what? It already has, to a large degree. Even as housing was melting down, Washington encouraged and enabled Fannie Mae and Freddie Mac to do more. As part of the stimulus package passed earlier this year, the caps on the size of mortgages Fannie and Freddie were permitted to back were lifted from $417,000 to $729,000. And as lenders have disappeared from the field, Fannie and Freddie have reassumed their leadership roles. In the second quarter of 2006, Fannie and Freddie accounted for 37.7 percent of mortgage bonds issued, a record low. But in the first quarter of 2008, the two firms accounted for nearly 70 percent of all new mortgages.

Without Fannie and Freddie, in other words, there isn’t much of a private mortgage industry. That is why, despite protestations, Washington’s economic policymakers must be considering ways to deal with the potential failure of these firms. The bonds of Fannie and Freddie can’t be allowed fail. But their stocks sure can.