WASHINGTON — Investors fell over themselves this week to sell shares of Fannie Mae and Freddie Mac while the front pages of the nation's largest newspapers raised the specter of a government takeover.
Officials in the Bush administration, Congress, and even the leading presidential candidates all tried to reassure the markets, making ever more explicit the government-sponsored enterprises' ties to, well, the government.
No one expects the administration to let Fannie or Freddie fail, and plenty of people don't even think the companies are in such sorry shape. But clearly the debate could use some elucidation, so we offer some answers to the following frequently asked questions:
Are Fannie and Freddie going to fail?
Highly unlikely. To be sure, both companies face significant hurdles, investor confidence and raising capital being chief among them. But right now, Fannie and Freddie have the two most important items to their ongoing survival: Their regulator says they meet its highest capital standard and they continue to be able to borrow in the debt markets. As long as both those facts remain true, there will be no failure.
So a bailout isn't needed?
That depends on how you define bailout. The situation remains volatile and is largely keyed to psychology rather than reality.
But psychology plays a big role in the collapse of most mortgage firms, and if Fannie and Freddie begin to have difficulty selling debt — thus maintaining liquidity — emergency action may be needed. Even so, that action is likely to fall short of a full scale government assumption of either company.
What could the government do?
Plenty, and all of it controversial. The Treasury Department — which has long maintained the GSEs' debt is not backed by the government — could reverse course and declare that it is. The Federal Reserve Board could open its discount window to Fannie and Freddie to ensure their liquidity. The central bank also could buy Fannie's and Freddie's debt or arrange for a third party to do so. It could also — a la its rescue of Bear Stearns & Co. in March — arrange for a third party to invest capital into Fannie and Freddie.
Fannie and Freddie can use the discount window?
The Fed has authority to open the discount window in extraordinary times, and the GSEs faltering would certainly qualify. Senate Banking Committee Chairman Chris Dodd said Friday the central bank was openly considering the move. The Fed declined to comment on this Friday.
It would need to establish a new lending facility for Fannie and Freddie, like the primary dealer credit facility it created when it started lending to investment banks in March.
"What access to the facility could mean is that one or both GSEs could immediately liquefy their [mortgage-backed securities] — especially their AAA subprime and Alt-A private ones — and, perhaps, calm investors," according to a client note from Federal Financial Analytics Inc. "The Fed can and will do whatever is needed to stabilize the market and, if it's a new discount window or additional support for GSE obligations held as collateral by primary dealers, that's what the Fed will do."
What about an outright takeover?
The Office of Federal Housing Enterprise Oversight has the power to put Fannie and Freddie into a conservatorship and run the GSEs while keeping their obligations off the government's books. But the agency does not have the power to shut a GSE down — yet. A bill pending in the Senate and passed by the House would give the regulator such receivership powers.
How likely is that?
Not very. The government will do what it has to to calm the markets. If it can avoid taking the drastic step of taking over the enterprises — like opening the discount window — it will do so. Still, so far the administration has relied on reassurances and those haven't helped much.
What role is politics playing here?
Less than you might imagine. Though the Bush administration has long taken a hard line against the GSEs, and warned of their systemic risks, it is largely united with Democrats in trying to quell any panic surrounding the issue.
A failed Fannie or Freddie is not in anyone's financial or political interests as it would likely have a severe and unpredictable impact on the already troubled mortgage market.
What's behind the panic? What changed in the last week?
Nothing really changed, but a Lehman Brothers report last Monday stoked fears that the enterprises are undercapitalized. The Lehman analyst said a change to accounting rules might force Freddie to raise $29 billion in capital, while Fannie would need to find $46 billion.
Those numbers sent shock waves through Wall Street, since finding $75 billion in very difficult in the current market. James Lockhart, OFHEO's director, stepped in to say he did not believe an accounting change should drive a hike in capital.
"A huge share of this is panic," Freddie chief executive Richard Syron told American Banker Tuesday.
"Markets are moved by information, but in periods like this, they are also moved by fear."
The situation was not helped by a string of alarming reports in major media outlets detailing government deliberations on a bailout.
But honestly no one knows how much capital Fannie and Freddie will ultimately need to get to the other side of the mortgage crisis, because no one knows how far home values have yet to fall, how many borrowers will default, and how big the losses will be.
As of March 31, Fannie held $42.7 billion of core capital — $5.1 billion more than required by OFHEO. Freddie held $38.3 billion, or $6 billion more than required by its regulator.
That sounds like a lot of capital.
It is until you consider Fannie had $843 billion in assets as of March 31, and Freddie had $802 billion. So that's capital equal to roughly 5% for Fannie, and 4.7% for Freddie.
Though that's above their 4% regulatory minimum, it's low when compared with commercial banks, which must hold 8% equity capital to be considered well capitalized.
The difference in ratios is due to the fact that mortgages were, until recently, considered low-risk, and the GSEs were meant to be highly leveraged to help provide the secondary mortgage market with liquidity.
Why have investors punished Freddie more than Fannie?
Fannie raised an additional $7 billion in capital in May, and while Freddie pledged to raise $5.5 billion, it has yet to do so.
What about the debt markets?
There is something of a Catch-22 going on there. Debt spreads have narrowed for Fannie and Freddie this week because many analysts perceive a government bailout in the offing. Thus, they are willing to buy agency debt because they think the government will soon step in.
But how they will react if the government takes no action is the $64,000 question, analysts said.
"I don't know how long the debt guys will hold out without action from the government," said Paul Miller, an analyst at Friedman, Billings, Ramsey. "That's the key to all of this."
If the debt market panics …
Fannie and Freddie are in trouble. Ditto if their second-quarter results are worse than expected and they must take large writedowns that push capital levels below required minimums.
If the near-collapse of Bear Stearns in March provided any lesson, it was that panics matter and can quickly engulf a firm.
But it's important to note we aren't there yet, and may never be.
