Top 15 For 2008 (No. 5): Fannie and Freddie Implode

January 14, 2009 5:45 PM EST

StreetInsider.com has put together its 'Top 15 For 2008' which chronicles our view of the most significant news on Wall Street during the tumultuous year.

Number 5: Fannie and Freddie Implode

In 2008, the crashing housing market and mounting foreclosures finally caught up to mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Collapsing balance sheets, liquidity issues and the wavering faith of foreign investors finally forced the U.S. government to nationalize the two government sponsored enterprises.

Created as federal agencies during the period following the Great Depression, to provide liquidity and stability to the U.S. housing and mortgage markets, Fannie Mae and Freddie Mac were chartered by Congress as private shareholder-owned companies in 1968 and 1970, respectively.

Although separated from the government, Fannie and Freddie held on to one key thing after the split - the implicit guarantee of the U.S. government. There was an implied view that if Fannie and Freddie defaulted the U.S. government would ante up.

Unlike banks and thrifts, that make home loans directly to consumers, Fannie and Freddie operate in the secondary mortgage market. The secondary mortgage market works like this:
A. Borrower applies for a loan at a bank
B. Bank evaluates the applications, often using Fannie and Freddie tools
C. Bank makes the loan to the borrower
D. Bank sells the loan to Fannie or Freddie, giving them funds to make new loans
E. Fannie and Freddie package the loans to create mortgage-backed securities, then sells them to investors

With the government 'implied' guarantee, investors flocked to the GSEs 'Agency MBS.' The Agency MBS paid better than treasuries, but still had the implied government guarantee. Fannie and Freddie were contributing to the American Dream and lining their pockets at the same time.

With 'funding for all' mortgage policies, a perception was building that home prices WILL NEVER GO DOWN.

This flawed perception on housing allowed Fannie and Freddie to aggressively build their balance sheets using enormous leverage. This perception also brought about competition, as banks and finance companies were issuing Non-Agency MBS, which is not associated with the GSEs, at break-neck speeds. Investor demand for all flavors of MBS was enormous. Based on the premise that home prices will never go down, the investors believed their investments were safe. Subprime and Alt-A loans dominated Non-Agency MBS and before long Non-Agency MBS outpaced Agency MBS. All the while, underwriting standards were getting weaker and weaker and LTV was getting higher and higher.

With all the easy money, housing prices went up, up up and new mortgage products were being developed daily to get people into the homes. The new home business was booming and speculators flocked to many of the hottest markets to make their fortunes.

Things were humming along great, until... BOOOOOOOOOOOOOOOOOOOOOOOOOOM!!!!!!!!!!

Eventually, the housing supply became too large and prices too high to be sustainable. Housing prices began to flatten out and even drop in some markets.

With no appreciation in home prices, delinquencies in the subprime market started showing up. When the market was hot, a subprime borrower could either sell the house or refinancing into a 100%+ LTV loan. But with house prices now flat to lower, this was no longer the case. Before long problems were spreading into Alt-A and other exotic mortgage loans. Even prime loans were showing signs of trouble.

Due to problems with the delinquent loans, the Non-Agency MBS market started seizing up, leaving Fannie and Freddie to pick up the slack. But housing prices continued to slide --- things were melting down.

With the decline in housing values, the balance sheets at Fannie and Freddie became extremely strained which forced them into the market to raise money.

Despite regulatory efforts to free up Fannie and Freddie to give more loans and ease their balance sheet pressures, housing got worse, further pressuring the GSEs. Soon potential investors in Fannie and Freddie were drying up. The companies needed more capital, but no one was there.

Due to the financial issues at Fannie and Freddie, investors in the Agency MBS market became nervous. If investors stopped buying Agency MBS, the entire mortgage market would seize up. With housing already in free fall, the federal government couldn't take this risks and in July of 2008 Treasury Secretary Henry Paulson announced an aggressive plan to provide much needed liquidity to the GSEs. Testifying at a July 15 Senate Banking Committee hearing on the aggressive plan, Paulson said, "If you have a bazooka in your pocket and people know it, you probably won't have to use it."

While the Treasury backstop reassured Agency MBS investors, with the government involved, investors in Fannie and Freddie equity and debt ran for the hills. Investors felt that a potential government takeover of the company would wipe out the common shares and take precedence over preferred and debt holders.

With market conditions getting worse, the fears were soon realized and on Sunday, September 7th, the U.S. placed Fannie Mae and and Freddie Mac into a conservatorship with the Federal Housing Finance Agency. To avoid financial armageddon, the government was forced to make their "implicit" guarantee on the GSEs "explicit."

It is my view that policies dating back to the Great Depression, which fostered easy mortgage money, created the mess we see today. The easy money artificially boosted the price of housing assets beyond the rate of inflation. Years and years of data showing growth in housing prices made it easy to perpetuate the great lie that "House Prices Will Never Go Down." This lie fed into the investors demand for MBS, which fed the system with billions for more loans. The system had created is a monster, and now the government is being forced to feed the monster to keep it going.

Related Categories

Insiders' Blog
Trader Talk

Stocks Mentioned

Related Entities

• Henry Paulson
• Top 15 For 2008

Comments

Add Your Comment

Name

Subject

Body

Verification can't see the text?
click here to refresh the image.
what's this?