Game Over?

October 09, 2008

The government acquired $1 billion in senior preferred stock in each company, with a 10 percent interest payment, and 79.9 percent interest in their outstanding common stock through warrants.  The companies' CEOs were dismissed and replaced by two finance industry veterans.  The government pledged to buy Fannie and Freddie guaranteed mortgage backed securities (MBS) while allowing their portfolios to grow through 2009.  After that, however, both would have to start shrinking their portfolios by 10 percent a year until reaching $250B.

On Monday morning, Sept. 8, investors rushed to the exits to dump both companies' outstanding common and preferred stock.  Fannie alone traded more than 332 million common shares in the first few hours.  The daily average is under 80 million shares.  The price dipped below $1 per share midday.

Why the Rush?

The best explanation I've heard for why the government moved in on both companies with such unexpected speed is that both Treasury and the Fed were being told by foreign investors, especially but not only China, that they had no appetite for more of the GSEs' debt offerings without an explicit move by the government.  These investors also were net sellers of the debt recently, driving up the GSEs' borrowing costs, keeping mortgage rates higher than other rates infuenced by the Fed, and raising the specter of a total meltdown in their debt cycle.

After that the GSEs' newly strengthened regulator, backed by new work they commissioned from Morgan Stanley, told both companies they were exercising their conservatorship powers and that was that.

I've reviewed the materials provided by the government over the weekend and have the following thoughts about this unprecedented move.

Pros

1. The plan will reassure domestic and overseas debt investors and keep capital flowing into the housing market when it is critically needed.
2. Fannie Mae and Freddie Mac remain the most important sources of mortgage capital in the US market at this time.  The proposed plan will enable them to continue to provide this important liquidity function.  There are no other financial entities that have indicated any ability or inclination to fill this need, and the government has no other ready mechanism to do it directly.  This plan will help keep the mortgage system operating through an unprecedented difficult period.
3. Actual taxpayer funds contributed to shore up the companies' capital structure will be invested only as needed after the initial $1 billion in senior preferred, with its premium return. Common shareholders are last in line for any reward.  All dividends to other shareholders have been suspended.  The market already (on Sunday, 7 Sept) has marked down outstanding preferred and common stock, hardly a bailout.  Common shareholders already have lost 90 percent of their value from a year ago, and preferred shareholders have lost nearly half the value of their holdings.  In return for the initial $1 billion investment, the US. Government has obtained warrants for 79.9 percent of the outstanding common stock.  The 2008 GSE book of business is being underwritten at higher fees and higher credit quality, creating the basis for financial recovery that likely will enable them to stablize and cover any costs to the taxpayer the plan involves.
4. The planned Treasury purchase of MBS will provide an important liquidity backstop if the companies' capital positions and participation by other investors limit the ability to make a market for the MBS.
5. The promised renewed focus on the companies' mission is important and welcome.
6. Retaining the companies in their current form will allow them to continue to carry out their liquidity purposes, leverage the deep competencies in their professional staffs, and give the government substantial depth in navigating the difficult course that lies ahead.  The US Government just gained control over nearly 10,000 very competent staff who will continue to be paid through the companies' own operations, not the taxpayer.
7. This stabilization will give the next Administration and Congress breathing room to thoughtfully consider what form, if any, government sponsored enterprises should play in the mortgage markets in the future.  It does not foreclose any options, but maintains their important functions while those considerations take place.  The announced ban on lobbying by the companies takes them out of the future discussion except as technical resources to the conservator.

Cons

1. While the renewed focus on the companies' mission is welcome, how this will be defined remains unclear. There needs to be more clarity on how large a role serving the mortgage needs of low, moderate and middle income homebuyers.
2. Fannie and Freddie are the dominant source of mortgage capital for multifamily housing.  It is a solvent and profitable business for both, with minimal losses.  Any moves by the conservator that negatively affects this will further decrease the flow of capital to housing that serves the low and moderate income market.
3. The companies' policy to delay taking delinquent mortgages out of pools and to continue paying principal and interest to investors has provided room for workouts and modifications.  If the conservator's plan curtails this practice there could be an uptick in defaults and foreclosures.
4. The announcement suggests that the current fee structure will be reviewed.  The higher fees now being charged are an important source of new revenue to help the companies offset losses.  Some portion of these losses is clearly the result of poor credit quality in the companies' own books.  But a much larger portion of their losses is the indirect result of reckless lending by banks and poor regulation by the government that allowed housing prices and homeowner leverage to get out of hand, leading to the deflation of a property value bubble that has depreciated all of their assets, performing and not.  As big as Fannie's loss rates are, they remain significantly below those of the industry in general and subprime and private label Alt-A lenders in particular.  Reducing their revenue stream now will extend the time it will take to rebuild their capital, which in turn will extend the likely term of a conservatorship.  On the other hand, the higher fees are making mortgage credit more expensive for low and moderate income buyers with good credit.  A balance must be struck between these two outcomes. 
5. Curtailment of the companies' charitable giving will hit community partners hard. Many of these are on the front line of helping to stabilize communities struggling with the mess created by non-GSE subprime lending.  None of the investment banks or others that willingly provided liquidity for this reckless lending are being forced to pay for this community damage. The announcement does not specify what will happen to the projected GSE contributions to the "Affordable Housing Fund" that is supposed to backstop FHA's new mortgage initiative, and later provide funding for desperately needed affordable housing for extremely low income households.  If the government plan wipes out these funds, FHA losses will have to be made up by taxpayers directly.
6. The announced intention to force the companies' portfolios into an annual 10 percent reduction to $250B each begs the question of what sources will make up this difference, or why it is sensible, wise or necessary prior to determining the best future course for the system.  There is no rationale offered for why $250B is the right goal.  This seems like an ideologically driven feature that predetermines the outcome of Congress' future decisions.  There is no analysis offered of the market's ability or willingness to absorb the share that the GSEs would shed.   It's unclear why having the US Treasury become the largest and/or last resort buyer of MBS in the US market is a smart or desirable move.
7. The GSEs should give high priority to community stabilization and preservation in their sales of REO from foreclosed properties.  The announcement is silent on how the conservatorship will affect this function.  If the GSEs do not forego potential income from these sales through discounts to insure homewners, not investors, and communities with effective plans for how to acquire, stabilize and steward them, the costs of foreclosures will simply cascade down to state and local governments and further erode the home values of neighbors who are not yet in trouble.  The conservator must balance these needs against that of raising money to offset losses to the GSEs from foreclosures.
8. Both Fannie and Freddie have made enormous contributions to affordable rental housing through their past investments in Low Income Housing Tax Credits.  Quickly exempting these credits from the companies' AMT limits would improve their capital position. Congress recently exempted going-forward LIHTC losses from AMT. Forcing the GSEs to write off the accumulated credits would be a perverse reward for being the single most active participants in this market in the past.

What do you say now, dear?

If any politician asked me, this is what I'd suggest s/he say about these events:

• The announced plan is an unfortunate turn of events.  But with serious doubts about buyers' willingness to remain in the GSE debt market, it should stabilize the most important source of capital for American homebuyers and homeowners.
• Congress and the next Administration must take quick action in 2009 to use the breathing space this initiative creates to carry out a serious and sober reassessment of how the mortgage system should be restructured to ensure the continued flow of capital without jeopardizing the taxpayer.  The needs the GSEs were chartered to meet -- standardization, liquidity, and access in the mortgage market -- remain critically important.
• The public-private GSE model functioned extremely well for 40 years.  It has provided access to long-term, fixed rate mortgages at a scale unrivaled anywhere else in the world.  This has been critical for low, moderate and middle income consumers by providing them with stable, affordable means to buy and maintain their homes.  While it may need significant reform, we should not assume that it cannot be designed, regulated and managed to work well for another 40.
• While Fannie Mae and Freddie Mac have become the largest and most critical victims of a "Wild West" system of under-regulated, over-stimulated primary market lending, no reform of these two companies will succeed without a serious and significant overhaul of how the primary market is regulated to protect consumers.