Why didn’t the Fannie-Freddie semi-rescue-plan announced over the weekend reassure the stock market?
It wasn’t really meant to reassure the stock market. It was meant to keep the investors around the world who buy the bonds and mortgage-backed securities issued by the two companies from freaking out, and seems to have succeeded on that front so far. But if the government actually has to step in and cover Fannie Mae’s and Freddie Mac’s losses, shareholders in the two companies will be wiped out. And even the partial bailout envisioned by Treasury Secretary Hank Paulson, in which Congress allows Treasury to buy stakes in the two lenders to improve their capital positions, would mean current shareholders would have to cede much of their stake to the government.
That explains why Fannie’s and Freddie’s shares are down. But what about the rest of the stock market?
Two things spring to mind. One is that the dramatic actions of the weekend have made clearer than ever that we’re still in the midst of a big-time financial crisis that won’t leave the economy untouched. The other is that the failure of California thrift IndyMac Friday–which left shareholders with zilch–has made investors at other regional banks and thrifts with big mortgage exposures extremely nervous.
What are Fannie and Freddie again?
The two “government-sponsored enterprises,” as they’re called, buy mortgages from lenders (banks, thrifts, and mortgage brokers), hold on to some, and repackage the rest as mortgage-backed securities. Between them the companies have about $5.1 trillion in debt and MBSes outstanding, about $1.4 billion of it (as of last summer; the number’s probably higher now), in the hands of foreign investors. Fannie was founded as a federal agency, the Federal National Mortgage Association, in 1938, then privatized in 1968 to get its debts off the federal government’s books. Congress created the Federal Home Loan Mortgage Corp. (Freddie Mac) as a private company in 1970 so Fannie wouldn’t have a monopoly. The debt issued by the two companies is explicitly not guaranteed by the federal government, but because of their origins investors have long acted as if it more or less was, demanding interest rates only slightly higher than those on Treasury bills and bonds. Since the savings & loan industry collapsed in the 1980s, clearing the way for Fannie and Freddie to become dominant players in the U.S. mortgage market, the assumption has grown that they’re also just too big and important to be allowed to fail. Turns out it was a correct assumption.
So who’s to blame for Fannie’s and Freddie’s troubles?
That’s a topic for much debate. Critics on the right have long lambasted the two companies as dangerous corporate/government hybrids that use their “implicit” taxpayer guarantee to sideline competitors and take big risks. There’s surely something to that–Megan McArdle has a good summary of these arguments here. But during the binge of truly insane lending from 2003 through 2006 that brought on the current housing crisis, Fannie and Freddie were mostly sidelined by government rules that restricted the sizes and kinds of loans they were allowed to make. They’re in trouble because they never anticipated a 20% drop in house prices nationwide, not because they caused the housing bubble and crash. I sort of made that argument Friday; Paul Krugman does it more elegantly today. Tanta at Calculated Risk, a former mortgage lender, splits the difference in highly educational fashion.
What happens now?
For now, Fannie and Freddie will keep the U.S. mortgage market going as semi-nationalized institutions (after seeing their market share squeezed down to 10% in 2005, they now account for the vast majority of mortgage lending in the country). Once things calm down it seems inconceivable that they’ll be allowed to continue to exist in their pre-crisis form. But Congress is a funny place when it comes to Fannie, Freddie, and mortgage lending in general, so who knows. The bigger question at the moment may be whether the Bear Stearns shotgun marriage, the Fannie-Freddie rescue, and the IndyMac collapse presage a more widespread nationalization of an insolvent U.S. financial system. If that happens you’d have to start worrying a bit about the creditworthiness of the U.S. government–and if foreign investors were really to start worrying about that, the dollar decline and financial angst we’ve seen so far might turn out to be a mere prologue. Chances are this isn’t quite over yet, folks.