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Government Bailouts (3 Part Series)

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William-CoxPart 1 – Where are we now?

You are most likely familiar with the 2008 bailouts of Fannie Mae and Freddie Mac. The bailouts have once again become newsworthy due to new documents being released in connection with ongoing lawsuits challenging the legality of how the bailouts were structured. I thought that it might be an appropriate time to review the bailouts and the potential impact they had on the markets. This article is the first of three that will discuss 1) Where we are now? 2) How did we get here? and 3) The impact on the markets? First I will start with a brief overview of the roles Fannie Mae and Freddie Mac play in the mortgage origination and securitization process.

How do Government Sponsored Enterprises Work?

Fannie Mae and Freddie Mac are referred to as Government Sponsored Enterprises (GSEs); they are private organizations with shareholders that are publically chartered by congress. While they are not explicitly guaranteed by the federal government, there is an assumption by investors that an implicit guarantee exists due to the critical nature of these two entities to the overall economy of the United States. It was assumed that if one or both of these entities were to fail that the federal government would step in to bail them out; essentially guaranteeing the GSEs. As a result of this implicit guarantee investors treat securities issued by the GSEs as quasi-government securities, requiring a small risk premium above treasuries. Now that the federal government has actually followed through with a bailout, the belief in an implicit guarantee appears to be validated and the risk premium is even less.

When banks originate mortgages they can either hold them on their balance sheet or resell them. Fannie Mae and Freddie Mac will buy conforming mortgages (based on their own criteria) from the originating banks, guaranteeing them and pooling them together (securitization process). These new Mortgage Backed Securities (MBS) will then be sold to investors. Since 2008 Fannie Mae and Freddie Mac have guaranteed approximately 60% of new mortgages in the United States 1. In theory this increases the availability of credit in the mortgage industry, makes banks more willing to originate mortgages, and reduces borrowing costs. This process is appealing to banks since after they sell the mortgage they are no longer at risk for the default of the borrower on the mortgage, they simply receive the origination fee for the loan and potentially the loan servicing fees.

GSE Bailout

On September 6, 2008 the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship. Fannie Mae and Freddie Mac currently have loans to the United States Treasury of $116.1 Billion and $71.3 Billion respectively; a total of $187.4 Billion. The United States Treasury holds warrants equivalent to 79.9% of the outstanding equity in the two GSEs and is currently taking 100% of the profits from Fannie Mae and Freddie Mac and sweeping these funds into its General Fund to be spent with no restrictions. The Shareholders, who maintain a 20.1% equity stake, are suing the Government related to the legality of the net worth sweep. 2,3

As of Q1 2016 the GSEs have paid the United States Treasury a total of $245.8 Billion in the form of dividends/profits, $58.4 Billion more than they have borrowed; the original $187.4 Billion is still outstanding. 4,5,6 To date legislation to bring the GSEs out of conservatorship has ground to a halt in congress. We do not predict any new work on legislation until after the November presidential election and the courts work through pending lawsuits. In my next article I will look at how we got to the point of the GSEs needing a bailout.

Figure 1

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William Cox, CMA
Investment Analyst

1 https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr719.pdf
2 https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr719.pdf
3 http://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/2008-8-7_SPSPA_FactSheet_508.pdf
4 http://www.freddiemac.com/investors/er/pdf/10q_1q16.pdf
5 http://fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2016/q12016.pdf
6 See Figure 1

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