Wall Street History

---

Wall Street History

09/12/2008

Fannie Be Tender...with my mortgage

Bull/bear readings, 9/17, 37.9 / 43.7

In light of the momentous events of the past week, I thought if this is a Wall Street History column I might as well put down for posterity the statement that triggered another round of market volatility. 

I have long said that the housing correction poses the biggest risk to our economy. It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie and Freddie Mac are critical to turning the corner on housing. Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability. 

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs (Government Sponsored Enterprises) will modestly increase their MBS (mortgage-backed securities) portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size. 

Treasury has taken three additional steps to complement FHFA’s (Federal Housing Finance Agency) decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares. 

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS. 

Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.  

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses. The federal banking agencies are assessing the exposures of banks and thrifts to Fannie and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital. 

The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below ‘well capitalized.’ The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations. 

Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing GSEs so they can better perform their mission, today’s action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions. 

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009. 

Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we’ve seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability….. 

Through the four actions we have taken today, FHFA and Treasury have acted on the responsibilities we have to protect the stability of the financial markets, including the mortgage market, and to protect the taxpayer to the maximum extent possible. 

And let me make clear what today’s actions mean for American and their families. Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today. 

A: A conservatorship is the legal process in which a person or entity is appointed to establish control and oversight of a Company to put it in a sound and solvent condition. In a conservatorship, the powers of the Company’s directors, officers, and shareholders are transferred to the designated Conservator [the person or entity appointed to oversee the affairs of a Company.] 

Q: What happens to the Company’s stock during the conservatorship? 

A: During the conservatorship, the Company’s stock will continue to trade. However, by statute, the powers of the stockholders are suspended until the conservatorship is terminated. Stockholders will continue to retain all rights in the stock’s financial worth; as such worth is determined by the market. 

While I will have more on the Freddie/Fannie bailout in my “Week in Review” column going forward, for now an opinion from the Financial Times’ Martin Wolf. 

“Formally, the Treasury has put the two institutions into a ‘conservatorship,’ which means they are no longer run in the interests of the shareholders; it has established ‘preferred stock purchase agreements,’ to ensure that each company retains a positive net worth; it has created a new secured lending credit facility for the GSEs and the Federal Home Loan Banks; and, finally, it is initiating a ‘temporary program to purchase GSE mortgage-backed securities (MBS).’…. 

“Was there an alternative to such measures?....The answer is No, for two reasons. 

“First, the institutions were unable to raise the capital they needed to offset the losses on their lending in the collapsing U.S. housing market. This threatened their access to finance. That, in turn, would have drastically curtailed their lending, which accounted for more than 80 percent of U.S. housing finance earlier this year. The result would have been even swifter declines in house prices and a deeper decline in domestic spending. The former might be no bad thing; the latter surely would be. 

“Second, the liabilities of these enterprises were held widely abroad, particularly by central banks and governments. A failure to guarantee these liabilities would have shaken confidence in the U.S. government and currency, possibly to a devastating extent. 

“Will the measures work? If the aim is to sustain the creditworthiness of the GSEs, the answer is Yes, unless there is a general flight from all U.S. government liabilities. The latter is possible, but extremely unlikely. 

“If the aim is to sustain lending to the housing market, it will, again, work. But it will also slow the needed correction in prices, so creating new losses for those who are persuaded to buy now. Some of those losses will ultimately fall on taxpayers. As the needed correction is slowed, the assumption that the GSE portfolios can be reduced from 2010 seems a fantasy. 

“What, finally, are the lessons, beyond the obvious one that it is idiotic to believe that the prices of any asset class can only go up? It is that the U.S. unwillingness to recognize that socialized risk demands public control has created not just a scandal, but a gigantic mess. 

“The U.S. public has ended up with an open-ended guarantee of the liabilities created by supposedly private enterprises. It is a bad place to be. As Mr. Paulson says: ‘There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form.’ 

“Amen to that. At some point, they will have to be broken up and sold off. Given the state of the housing market, that happy day is a long way off.” 

---