Fannie Mae (Federal National Mortgage Association – FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation – FHLMC) are without a doubt the leading economic story in the US over the past month.
FNMA:

  • Privately owned company (not government owned, publicly traded)
  • Created in 1938, became publicly traded company in 1968
  • Role: supply funding to banks in order to provide mortgages to the public (called the secondary mortgage market).
  • A GSE (federal Government Sponsored Enterprise). As such, FNMA has had an implicit guarantee backed by the US Federal Gov’t.

FHLMC:

  • Created in 1970- in the Emergency Home Finance Act of 1970.
  • Does the same job as FNMA.     

What’s the Issue:

Fannie & Freddie are at risk of going under. Freddie had net worth of -$5.2B at the end of 1Q 2008 (yes, a negative net worth).  Their stock has been pummeled because of recently discovered business practices and poor balance sheets (insolvent).  This is a huge issue for the US economy since approximately half US mortgages are funded with Fannie & Freddie funds. Indeed, the 2 organizations guarantee $5.2T in mortgage bonds.  As of the date of this article (July 28 ‘08), FNMA’s trailing 1 year stock price has fluctuated from 6.68 – 70.57. Freddie’s stock price has been in the range: 3.89 – 67.20 (see diagram). Both stocks are trading near their bottoms.  Our clients have not held asset-backed bond funds since last summer – avoiding these huge losses.

Although the GSEs had $5.2T in debt, they only had approx $83B in core assets. This represents a leverage / gearing ratio of 65 to 1. This kind of ratio would never be permitted in a commercial bank with AAA credit ratings.

 

Proposed solution to FNMA / FHLMC situation:

In order to propose an intelligent solution to the problem, one needs to understand the unique situation for Fannie & Freddie. These institutions have been permitted to run amok with tax-payers on the hook – for years. It has been said that the profits were privatized and the risks socialized. This is true in that a large portion of the profits went to share-holders of the companies, but because of an implicit guarantee by the federal government – shareholders knew they would have something of a backstop.  Now there is an explicit guarantee being offered by the Federal government in supporting Fannie & Freddie. 

                  

The currently approved solution is to:

  • increase Fannie & Freddie’s line of credit with the federal gov’t
  • have the federal gov’t explicitly guarantee Fannie & Freddie’s debt
  • have the government buy Fannie & Freddie’s shares if need be (bail out!!!).

 

Be angry with regulators. While Fannie & Freddie were operating a printing press of profits, they were paying the top 5 Sr. Mgrs $199M combined in 1998 through 2003. To ensure a continued gravy train, top executives paid lobbyists to protect their turf from regulators.  The same management would still be pillaging if they were not fired in 2003/2004 for accounting scandals.

 
How does this affect my investments:

Had Fannie & Freddie been allowed to become insolvent and fail (default on debt), foreign investors would bolt from the US bond market – including purchasing US government debt. Since the US federal government continues to finance its budget with foreign capital (living beyond our collective means), we could well have seen the US dollar in a free-fall since no one would be buying our bonds. This in-turn would put pressure on the government to raise interest rates offered on bonds – the opposite to what is needed to stop a recession or depression from occurring.

                    

Because bonds issued by Fannie & Freddie had previously not been explicitly guaranteed by the US government, they paid higher interest rates than treasuries. Fannie & Freddie bonds (like other GSEs) still pay higher interest rates than treasuries, but now they are both explicitly guaranteed by the federal government. Some say this is a free lunch and an opportunity to be paid a higher interest rate for the same risk. Treasuries and bonds from Fannie & Freddie may have similar risk (of default), but you have to be able to withstand the volatile price swings in Fannie & Freddie’s bonds. As a result, we’re sitting on the fence for another month or two before we start buying mortgage-backed bond funds from a GSE.