The Fannie and Freddie Bailout Continues: Do They Now Need $800 Billion?
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According to the New York Times, Fannie Mae and Freddie Mac are in negotiations with the Treasury to increase their credit lines from $200 billion each. When Fannie and Freddie were placed into conservatorship on September 7, 2008, the Treasury Department “effectively guaranteed” their debt through a senior preferred stock agreement that made $100 billion available to each of these government-sponsored enterprises (GSEs) so they could maintain a positive net worth. By committing to provide seemingly unlimited support to cover losses, the Treasury intended to help reduce Fannie and Freddie’s borrowing costs, as creditors would clearly feel more secure buying their debt if the taxpayers were explicitly on the hook for the first $100 billion of losses at each institution.
However, as the housing market deteriorated, Fannie and Freddie lost a combined $109 billion in 2008. With losses continuing to mount, the $100 billion credit lines proved to be inadequate to assuage creditors’ concerns. In response, the Obama Treasury Department increased taxpayer support to $200 billion each on February 18, 2009. Now, even that amount of money is proving to be inadequate to support the debt of Fannie and Freddie, so the two entities are now negotiating to secure an even greater backstop from Treasury.
In July 2008, Congress passed H.R. 3221, which grants temporary authority to the Treasury Secretary to purchase unlimited amounts of securities issued by Fannie and Freddie. While the authority to provide additional capital to the GSEs ends on December 31, 2009, Section (2)(C) makes clear that the “authority of the Secretary of the Treasury to hold, exercise any rights received in connection with, or sell, any obligations or securities purchased is not subject” to the expiration. This provision was necessary to entice creditors to buy longer-dated GSE notes. For example, Fannie and Freddie would have a difficult time selling ten year bonds if the creditors believed that the Treasury’s authority to backstop Fannie and Freddie securities expired after only one year. The problem with this section, however, is that it ultimately authorizes the Secretary to double (again) the credit lines for the GSEs. Put more bluntly, the Treasury has blank check authority to backstop the GSEs, as long as it makes any new commitments before the end of this year.
How could $400 billion ($200 billion each) be inadequate? There are three reasons:
1. The extraordinary losses from bad business decisions made in 2003-2007 when both GSEs made enormous bets on bad mortgages;
2. Inadequate regulation, which allowed Fannie and Freddie to operate without a meaningful amount of capital – so they had almost no buffer against losses; and
3. The Obama Administration’s decision to use Fannie and Freddie as instruments of federal housing policy, particularly as it relates to devoting new resources to loan modifications.
At the end of 2007, Fannie and Freddie had about $900 billion in combined exposure to subprime mortgage products (defined as loans made to borrowers with FICO scores less than 620 or loans made to borrowers without any verification of assets, employment, or income). This exposure came in two forms: large purchases of asset-backed securities (ABS) collateralized by subprime mortgages and straight purchases of “Alt-A” (a cut above subprime) and subprime loans directly from originators.
While the purchase of subprime ABS was relatively steady from 2004-2007, both Fannie and Freddie dramatically increased their direct purchases of these suspect loans after 2004. For example, Alt-A loans accounted for about 20% of mortgages purchased by Fannie Mae from 2005-2007 (p. 134 of pdf). As of mid-2009, 84% of the GSEs’ subprime ABS had been downgraded. The prices for these loans have also fallen dramatically as default rates on subprime and Alt-A mortgages soared. Worse, because the GSEs acquired so many bad loans at the height of the bubble, the actual loss rates on these defaulted mortgages have been several times higher than what most analysts previously thought was even possible.
The icing on the cake was that Fannie and Freddie held virtually no capital to absorb these losses. As part of the Federal Reserve’s “Supervisory Capital Assessment Program” (SCAP), or “stress test,” a well-capitalized bank was defined as an institution with a “Tier 1 Common capital to risk-based assets ratio in excess of 4% at year‐end 2010” after suffering losses from an adverse economic scenario. As of March 31, 2008 – well before the defaults had even begun to accumulate – Fannie Mae had a Tier 1 common capital to risk-based assets ratio of 0.98%. Freddie Mac’s Tier 1 common capital ratio was even worse – it could not be measured because it held no tangible common equity.
The Obama Administration’s decision to use the GSEs to refinance mortgage borrowers has accelerated the losses. In the third quarter, Fannie Mae reported $7.7 billion of losses on loan modifications, most of which were instigated by the government. This is on top of nearly $14 billion of credit losses on bad mortgages from 2005-2007.
According to its June 30 capital assessment, the Federal Housing Finance Agency estimates that in addition to the $111 billion already injected into Fannie and Freddie, the Treasury would have to invest $110 billion more just to bring their capital up to the inadequate 2008 levels. While $100 billion more would seem possible given the scale of the exposure to bad mortgages, this totals about $320 billion – an amount that can be accommodated under the existing $400 billion capital support.
An increase in the senior preferred stock agreement, or the credit line, at this time could mean one of two things. It could mean the Obama Administration wants to delay Congress from taking action to resolve the status of the GSEs for at least another year. Right now, the Administration is scheduled to release their long-term plan to reform the GSEs in February. A big increase in the credit line at the end of this year would be a strong signal that the Administration does not intend to make fixing these institutions – once and for all – a top priority next year.
Or it could mean the Administration wants more flexibility to use the GSEs for other loan modification activities that were not explicitly authorized by Congress. Either way, it would violate the spirit of the July 2008 law (if not its letter), which was to provide the Administration with the authority to avert the crisis that would have been brought on by a GSE default. Congress has an obligation to intervene on behalf of taxpayers and rein in an ongoing bailout that threatens to wreak havoc with the nation’s mortgage markets, and its public finances.