Fannie Mae and Freddie Mac rejoin the federal government

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Can someone explain why the government created companies that are now run by private shareholders? I’m having trouble understanding what the advantage is. Taxpayers are still clearly at risk so it seems that the shareholders can capitalize and then, should something go wrong, taxpayers will have to bail them out. Wouldn’t it be better to have these institutions run by the government entirely?

Those excellent questions about Fannie Mae and Freddie Mac were asked Saturday by commenter Justin C. This (Sunday) morning, Treasury Secretary Hank Paulson and Federal Housing Finance Agency (FHFA) director James Lockhart officially unveiled their answer to the last one. Yes, they effectively said, it would be better to have the two giant mortgage lenders run by the government–at least for now.

I bailed out Freddie Mac, and all I got was this lousy T-shirt

“Government support needs to be either explicit or non-existent,” Paulson said today. Through the end of 2009, at least, it’s going to be explicit. The FHFA has taken over the two companies as a conservator, and Treasury has entered into contracts in which it pledges to keep Fannie and Freddie solvent and they in turn give Treasury the right to acquire up to 79.9% of their common stock for a nominal fee. Treasury also committed to buy lots of the companies’ mortgage-backed securities for the next couple of years, which should keep mortgage rates down. Both companies will be getting new CEOs (former Merrill Lyncher and TIAA-CREFer Herb Allison at Fannie and former U.S. Bancorper David Moffett at Freddie) and are suspending all dividend payments, but their common and preferred stock will continue to trade.

(More after the break.)

Determining what that stock is worth will be an interesting guessing game for investors over the coming months. Basically, the more taxpayer money is used to shore up either Fannie or Freddie, the less the stock will be worth. Freddie, with big questions being raised about the adequacy of its capital reserves, currently looks to be the more likely of the two to need major intervention.

Concerns that a collapse in price of the companies’ preferred shares might wipe out a lot of banks that own those shares–which I wrote about yesterday–were partially dismissed today by Paulson. “[W]hile many institutions hold common or preferred shares of these two GSEs,” he said, “only a limited number of smaller institutions have holdings that are significant compared to their capital.”

But back to Justin C’s questions. Why were Fannie and Freddie allowed to operate as private companies with implicit government backing? The history is that Fannie, created as a government agency (the Federal National Mortgage Association) in 1938, was privatized during LBJ’s administration to get its debts off the federal government’s books. Then Congress created Freddie (originally the Federal Home Loan Mortgage Corp.) so Fannie wouldn’t have a monopoly.

So basically the motivation behind the creation of these strange public-private entities was an accounting subterfuge. Their debts weren’t counted as government debt, but investors assumed that they were guaranteed by the government. In the 1970s Fannie and Freddie were both still reasonably small enterprises, so this wasn’t that big a deal. But the collapse of the S&L industry in the 1980s left them the dominant force in the U.S. mortgage market. And until recently they (particularly Fannie) were able to wield their wealth and lobbying prowess to fend off all Congressional attempts to rein them in.

It should be noted that the two firms did a lot of good, too. For one thing, they made it possible for tens millions of Americans to buy homes more cheaply than they could have otherwise. Fannie and Freddie don’t make loans themselves, but buy them from banks and mortgage brokers and then either repackage them as mortgage-backed securities to be sold to investors or hold on to them. And rates on the loans that the two firms are allowed to buy (generally fixed-rate loans below a certain size) are invariably lower than on the loans they can’t.

Fannie and Freddie also can’t really be blamed for the insanity that overtook mortgage markets from 2004 through 2006. Both firms were under pressure to cut back on their lending after some accounting shenanigans, and their underwriting standards generally kept them away from the riskiest sorts of loans. Their market share plummeted as Wall Street firms eagerly snapped up hundreds of billions of dollars worth of mortgage junk.

Now, with Wall Street licking its wounds and banks and thrifts lending cautiously, Fannie, Freddie and the more explicitly government-guaranteed partnership of Ginnie Mae and the Federal Housing Administration are pretty much the only things keeping housing markets going.

The main reason Fannie and Freddie are in trouble despite their limited exposure to the last crazy years of the housing bubble is because neither regulators nor either firm’s risk managers ever contemplated a situation where house prices nationwide would drop 25% or 30%–as seems likely to happen before the current housing swoon runs its course. This failure to plan for a housing bust was unconscionable. But at the same time, if the Feds were to punish Fannie and Freddie for it by forcing them to stop buying mortgages, house prices would drop even more, making the situation even worse. Hence the bailout, and the particular form it has taken.

It is times like these that make the need for government-backed mortgage providers glaringly obvious. What’s far less clear is what they should do with themselves during the good times. As Paulson said this morning, that’ll be the next Administration’s job to figure out.

Update: Yet more Fanniefreddiefun here.