The tales of Freddie Mac and Fannie Mae, the tortured Government Sponsored Entities (GSEs), are rich with paradoxes. A theme of irony pervades their history, their decline, nationalisation and prospects.
First, the companies long behaved as if they were private, while they financed themselves as if public. The mortgage guarantee business, for which they were created, is simple enough: to underwrite and purchase conservatively written loans. However, by the mid-1990s, the GSEs realised they could parlay their low cost of funds, buying their own securities and generating the income between the cost of funds and the securities portfolios. It was the portfolios that led to their Waterloo this summer, and triggered the solvency problems.
As a second twist, Freddie ended up in much worse shape than Fannie, which had hoped to squeak though, by charging more to guarantee loans, increase earnings and preserve capital. Fannie had already spent more than $1 billion (£538m) on revising its accounting system in 2004, and had made improvements. The company had even raised about $7 billion in new capital this year, while Freddie dithered, and raised none.
Morgan Stanley, which performed the last round of accounting before the government took over, was more critical of Freddie’s health. “The Treasury would not allow Fannie to escape conservatorship, when it took over Freddie. But the markets would have come down on Fannie in a couple of days anyhow,” says Allan Krinsman, a New York attorney at Strook & Strook & Lavan.
On July 11 Henry Paulson, the treasury secretary, described his newly granted authority as a bazooka, assuring investors that, “today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission”.
So why did the government step in on September 7, rather than waiting a little longer? The consensus is they chose a date that occurred after the two political conventions and well before the general election. “People came up with excuses, but it was the political angle that counted,” says Krinsman.
The third irony proved particularly bitter for GSE shareholders. Uncle Sam’s decision to intervene was driven foremost by concerns that foreign central banks, who were major agency bondholders, might lose confidence and punish the dollar.
Foreigners owned about a quarter of the $5.2 trillion in agency debt, with China in the lead at $376 billion. Over the summer, it became clear that the foreign banks were dumping the bonds, which showed up in the rising spreads.
“They should have been trading at about the same price as government debt, but were now 100 basis points higher,” reports Elisa Parisi, a banking and finance analyst with RGE Monitor, an economic research firm.
“Those countries had us over a barrel with their huge dollar reserves, which they could switch to, say, euros, if they were unhappy about US-dollar based institutions defaulting,” says Michael Edesess, chief investment officer at Denver-based Fair Advisors. The consequences of a collapsing dollar would be highly inflammatory.
The bondholders did survive, in this odd turn of fate. On the covering of every securities offering, Krinsman points out, the words were printed clearly that the GSE bonds were not backed by the full faith and credit of America. Yet it turned out they were, after all, and a long-held perception became a reality in the end.
The drama has turned all the traditional political positions on their heads. Democrats had always favoured increasing affordable public housing and encouraged the public aspect of the GSEs. Free market-loving Republicans hoped that private companies would take over the guarantee functions. In fact, both parties benefited for years, as they could help promote cheap housing without increasing public debt.
“Democrats can now say that unfettered capitalism isn’t working, while Republicans have more of a problem with that narrative,” says Antony Page, professor at Indiana University School of Law. “It’s a fine line to walk.” Even the shape of the nationalised firms may evolve as a fifth irony. Normally, in the wake of a takeover, one would expect the target companies to decrease and shrink.
In this case, however, it has been structured so that the GSEs become even more active for the next two years. Instead of contracting, after the presidential election they will be under added pressure to add mortgages. After 2010, they are supposed to reduce their portfolios by 10%, but that is down the road.
“If you wait long enough, you can even go back to the future,” Krinsman points out wryly. Fannie Mae, which was founded in 1938 as a part of Roosevelt’s New Deal, was only privatised in 1968, so as to segregate it from the national budget and the fiscal pressures of the Vietnam War. Freddie Mac was then spawned in 1970, so that Fannie could not enjoy a monopoly, controlling 90% of the secondary mortgage market. Now both return to public roots and everything old is new again.
Finally, insult may be added to injury. Remember that the conservatorship plan has never been passed by law, and Congress has had almost no say in it. Starting in 2009, the newly elected lawmakers can change everything the Treasury has done.
Paulson has made clear that the solution is temporary, and that eventually the GSE’s should define their identities, either to be public or private. “The funny thing is that he himself has not made the decision, and it will be up to the next administration to choose,” says Parisi.
What is likely to play out? Congress is scheduled to hold post-mortem debates. According to the terms of the takeover, it is mandated that the charters of Fannie and Freddie be changed within the next couple of years. Various models suggest they might morph into all sorts of forms, from being chopped up and sold off piecemeal, to transforming into pure government agencies.
As China’s Chairman Zhou Enlai once famously remarked about the consequences of the French Revolution, it is too early to tell.