About Fannie and Freddie…

Story Highlights:

• Since Wednesday, the status of mortgage heavyweights Fannie Mae and Freddie Mac changed little materially. But Friday morning, shares of both firms fell steeply.
• Government statements and communications from the companies themselves insist Fannie and Freddie remain well-capitalized.
• Should they need to raise capital, there are a number of avenues available to them—private sources, the Fed's discount window, or even a direct government infusion.
• None of these actions are cause for extreme worry—what we would fear more is an extreme government regulatory backlash.

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Mortgage heavyweights Fannie Mae and Freddie Mac garnered much attention in the press and on Wall Street this week. (For more background on what's got people spooked, see Wednesday's (7/9/2008) cover story, "Of Whipsaws and Rumors".) Since Wednesday, the story has changed little materially. But Friday morning, shares of both firms fell steeply.

Fannie Mae, Freddie Mac Face More Pressure as Stocks Swoon
By Deborah Solomon, James R. Hagerty, Gregory Zuckerman, and Craig Karmin,
The Wall Street Journal

The immediate source of Friday's speculation seemed to surround Bush administration meetings discussing Fannie and Freddie collapse "contingency" plans. While this understandably reminded folks to be fearful, it should be noted that the president's administration has regular contingency plan meetings on just about everything under the sun, no matter how improbable—and we should probably thank them for it. Discussions in and of themselves don't necessarily portend action (an excellent rule of thumb for analyzing just about any political situation).

As for the continuing worries over the companies' solvency: Under current accounting requirements (which seem unlikely to change at the moment), Fannie and Freddie's balance sheets display mainly prime loans, of which a very small percentage are delinquent. And bear in mind neither is exclusively a mortgage lender. These firms deal in many forms of credit, from credit cards to college loans. Additionally, both government statements and communications from within the companies themselves insist Fannie and Freddie remain well-capitalized.

Let's be clear: This entire episode in some sense boils down to accounting. This isn't to say there aren't real problems tied to mortgage debt, but at this juncture the actual solvency of both companies hinges on a potential change in accounting rules, not explicit market conditions.

Fannie and Freddie could yet continue well-capitalized and able to weather weakness in the housing market with or without government assistance. Or the government might force new accounting rules on Fannie and Freddie and require them to shrink their balance sheets. Traditional mortgage lenders, already hurt by a difficult mortgage-backed security market, would have to hold even more loans on their balance sheets as the usual buyers (Fannie and Freddie) are unable to take them on. To make this switch feasible, most mortgage originators would likely offer more variable rate mortgages over fixed rate loans.

In the event potential balance sheet losses must be covered, the two companies would need to raise in the neighborhood of $10-20 billion each in additional capital. If necessary, the capital may still be raised privately or through an indirect source of government aid like the Fed's discount window.

Bernanke Tells GSE Discount Window Open
By Patrick Rucker, Reuters

On the other hand, if the government does need to step in more directly, $10-20 billion is a drop in the Federal bucket—compare that figure to the recent $150 billion spent on the rebate checks.

Such aid might take the form of a government capital infusion through purchase of common stock, preferred stock, or subordinated debt. While the first would be the most helpful from a leverage improvement standpoint, it's unlikely the government would want to be in the unusual position of being a shareholder. The more politically palatable option (and therefore more likely) would be subordinated debt or preferred stock.

There's an acute irony here: The US government citing Fannie and Freddie for "irresponsibility" is like a parent giving their kids a Snickers bar at 8 PM and then scolding them for climbing the walls at bedtime. Let's not forget the government is essentially the enabler of Freddie and Fannie's business model. Without the US's implicit backing, one could strongly argue neither company would be in this position in the first place. Risk of failure is what keeps most firms prudent. Take away that ultimate risk and folks tend to get a little looser.

Whatever the scenario, it's our guess that should the government step in at some point, direct support would take the form of capital infusions backed by either preferred stock or subordinated debt, but they will shy away from draconian measures significantly shrinking the mortgage market. Government intervention, while still by no means a sure bet, could in this case be helpful if it improves sentiment while avoiding major legislative overhauls.