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Giant mortgage hybrids, still playing critical role, left in limbo by politicians

REUTERS/Shannon Stapleton
Seven years after the federal government bailed them out, Fannie Mae and Freddie Mac are still the dominant players in home mortgage finance.

If you’re a homeowner with a mortgage, or a taxpayer, tune in. You may want to know more about the ongoing, largely under-the-radar skirmishes unfolding as Washington and Wall Street insiders battle over the future of Fannie Mae and Freddie Mac.

During the 2007-09 financial crisis, it was almost impossible to get a home loan without a guarantee from one of them. Then, despite strong criticism of their role in the subprime crash that sparked the crisis, they were left out of the Obama-backed Dodd-Frank overhaul of financial regulation. Now, seven years after the federal government bailed them out, they are still the dominant players in home mortgage finance. They have returned to profitability, repaying the government and then some for the bailout, yet Uncle Sam has been siphoning away their profits to reduce the federal deficit. They remain caged in federally regulated “conservatorships” set up in 2008, dependent on lines of credit from the U.S. Treasury and in effect nationalized by the government, but they lack the capacity they need to rebuild their capital. In short, they remain as incredibly important enterprises, yet they are living in limbo.

Guy Cecala is CEO and publisher of Inside Mortgage Finance, a Washington news service that has followed the home finance industry for years. He says the shortcomings of Fannie and Freddie can be fixed. In Cecala’s view, the most practical solution would allow them to come out of the conservatorships and to rebuild their capital, with improved safeguards and better oversight. Unfortunately, he adds, the most likely prospect over the near term is more inaction. 

Shutdown: Not such a good idea?

President Obama, leaders of both parties in Congress, private sector influentials and various others have pledged to put Fannie and Freddie out of business. This has long been a goal of conservative intellectuals and politicians, convinced that the government should not be in the housing finance business. But while the two agencies’ numerous critics have come up with many proposals for how to replace these two entities, skeptics stress there is no assurance that any of these plans would work.

Tim Pagliara, an activist investor and the CEO of CapWealth Advisors in Nashville, founded a group called Investors Unite to advocate for Fannie and Freddie investors. Pagliara says the two entities are too important to be wound down. “It’s political theater to think they can shut them down,” he says. “That’s folly.”

Guy Cecala cites market share numbers from his firm that show Fannie and Freddie originating home loans currently accounting for almost half the worth of all of America’s home mortgages [PDF]. In Minnesota, their share is modestly higher, probably around 52 percent. That’s because a lower portion of the value of all of Minnesota’s home loans is in “jumbo mortgages” (loans too large to qualify for Fannie/Freddie participation) than in East or West Coast areas with higher home prices.

Today, Fannie and Freddie have about $5 trillion in securities outstanding. Close to a fifth of this amount is held by the Chinese and Japanese governments and other foreign parties. That means these investors may well own chunks of the homes on the street where you live.

Unique status of Fannie, Freddie

Fannie and Freddie are hybrids — “government-sponsored enterprises,”  part private business and part government agency — that have benefited from private investment and various forms of backing from the government. They operate much as publicly held companies do in that they report their financial results regularly to stockholders. In 2014, they paid more federal income taxes than all but three U.S. corporations, according to Pagliara. In a typical mortgage deal, a home lender approved by one of these two entities swaps a package of, say, 10 $200,000 mortgages for a $2 million mortgage-backed security guaranteed by Fannie or Freddie. Then the enterprise immediately turns around and sells the security to investors.

Fannie was created in 1938 as a Depression-era vehicle to spur home ownership by buying mortgages from banks that loaned money to homebuyers. In 1968, President Johnson and Congress gave it hybrid status, in the process getting its liabilities off the government’s books. Two years later, Freddie was set up as a competitor endowed with similar benefits. Before the bailout, there was a near-universal belief that the government would rescue them should trouble arise, despite official denials that this would happen.  

Fannie is generally credited for the success of the 30-year fixed-rate mortgage, a crown jewel of the American dream and still the mortgage of choice for most home borrowers. Both agencies mushroomed as many Americans embraced with gusto the utopian claim, which turned out to be bogus, that home prices would always march upward.

Abuses at these entities began piling up in the 1990s, eventually blackening their reputation. Today, there is widespread agreement that they should shoulder some of the responsibility for the subprime crash and subsequent financial meltdown, but debate rolls on about how much to blame them. Like the large banks the government also bailed out, they were seen as too big to fail.

Watchdogs on the scene

Two financial journalists with Minnesota roots, Bethany McLean and Gretchen Morgenson, have been investigating the situation. McLean, who grew up in Hibbing, is a contributor to Vanity Fair and CBNC and a columnist for Fortune magazine. In her latest book (“Shaky Ground: the Strange Saga of the U.S. Mortgage Giants,” published three months ago) she says the U.S. government is using Fannie and Freddie as cash cows to make the federal deficit appear smaller than it actually is. “Because most American homeowners don’t know that they are in an intimate financial relationship with these enormous companies, it’s left to the interest groups and the politicians to fight out their future in private, and thus far that hasn’t produced happy results.” She warns that if market conditions destabilize the two entities, “they don’t have a cushion, and the effects on the American homeowner – and even on U.S. foreign relations, because of the large financial interests of other major powers in Fannie and Freddie’s debt – could be devastating.”

Morgenson, who graduated from St. Olaf College in Northfield, is the “Fair Game” columnist for the New York Times. Her 2011 book (“Reckless Endangerment,” written with housing finance analyst Joshua Rosner) is an exposé of abuses at Fannie and Freddie in the years leading up to the 2007 subprime mortgage crash. This year, Morgenson has focused more on the missteps of insiders, in both the government and the private sector – in dealing with the two entities.

Insiders slip into revolving door

This month, she reported that influential mortgage industry insiders were moving back and forth in a “revolving door” between regulatory agencies and the private sector to help craft policies to wind down Fannie and Freddie. In a lengthy investigation published by the Times (Dec. 7), she singled out three housing industry leaders formerly with the Obama administration now advocating for phasing out Fannie and Freddie in moves that would benefit the nation’s largest banks. Morgenson interviewed Richard Painter, a law professor at the University of Minnesota who was the chief ethics lawyer at the White House under President George W. Bush. She quoted him saying that the three executives might have violated a federal statute restricting former government officials from advocating for parties they regulated while in government. The three denied any violations.

In a follow-up story (Dec. 13), Morgenson reported that the Obama administration has imposed far tougher terms on Fannie and Freddie than on large banks since bailing out the two entities and these banks in 2008. She noted that lawyers for the Times have asked the judge overseeing litigation in a case brought by Fannie/Freddie investors against Obama administration regulators to release thousands of pages of documents the regulators insist should be sealed.

At least 20 such lawsuits have been filed across the country against the federal government largely by hedge funds, but also by other institutional and individual investors. They are angry Fannie/Freddie shareholders, charging that the federal government’s moves in 2012 to bar the two companies from paying dividends and to sweep their profits into the U.S. Treasury were illegal seizures that have seriously depressed the prices of the two stocks. As Bethany McLean observes, they “just happen to be some of the country’s wealthiest investors and, unlike most people, they can afford to fight.” She notes that Richard Perry, a Democratic Party power player who heads a $10 billion hedge fund, has retained Theodore Olson, solicitor general under President George W. Bush, to represent Perry Capital in one of the lawsuits.

Strange bedfellows

These investors' interests in strengthening Fannie and Freddie generally align with those of many community activists advocating on behalf of lower-income homeowners and renters. Guy Cecala calls this an alliance of strange bedfellows. John Taylor is president of the National Community Reinvestment Coalition (NCRC), an association of more than 600 community-based organizations that promote access to basic banking services such as credit, savings and affordable housing. This fall, Taylor again rejected the views of Obama officials and congressional representatives who want to eliminate Fannie and Freddie.

“The most sensible path forward for the housing finance system is to recapitalize Fannie Mae and Freddie Mac, take them out of conservatorship and build on the reforms of strong supervision and oversight of the enterprises started in 2008,” Taylor said.

The Minnesota Asset Building Coalition, which includes scores of community organizations throughout the state, works with the NCRC. Chip Halbach is executive director of one of those organizations, the Minnesota Housing Partnership. Halbach says Fannie and Freddie deal with parts of the housing market underserved by the private sector acting alone. His sense is that no significant changes in Fannie and  Freddie will occur until after a new administration comes to power in the White House in 2017, but he says the partnership will be monitoring the situation.

Meanwhile, a fresh reminder of the bad old days of the financial meltdown is coming to theater screens across Minnesota today (Dec. 23) when “The Big Short” arrives. This entertaining movie, based on the book of the same name by author Michael Lewis, fingers Wall Street as the culprit. Hey, close observers might say. Don’t forget Fannie and Freddie.

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Comments (2)

"Today, Fannie and Freddie

"Today, Fannie and Freddie have about $5 trillion in securities outstanding."

Politics, shareholder gripes and public preferences aside, how could the above ever be unwound? It's a staggering figure even if much of it is notional.

$143 Billion Reasons the US Government will take the warrants

The earnings of a combined Fannie Mae / Freddie Mac are approx. $15 Billion per annum. At a 12 to 1 P/E ratio, the value of 15 Billion times 12 equals $180 Billion. Multiply this 180 number times 79.9% and the result is $143 Billion dollars in equity value recovery through the sale of equity warrants for the US Government. If the US Government closes the GSE's this amount is lost to the US Treasury. If the US Government creates another entity from scratch to support the mortgage market, they would have to raise several hundred billion in private capital so that the US Government would not have capital exposure in the future and the US Government could walk away from the current implicit / explicit backstop. This $143 Billion number does not take into account additional tax revenue from gains that current private capital / shareholders would realize which could also be recovered by the treasury. The alternative of capitalizing on the value of the warrants would value the remaining equity of the company at a value not less than $37 Billion amount. This $37 Billion could be used to satisfy preferred and / or common equity stock holders. Also, the cost the US Government may incur for selling new securities in order to capitalize a new entity may be as much as 1% to 3% of the funds raised charged by the Investment Banks selling the new securities as well. Sooner or later, I believe the US Government and Congress will need to sign off on this solution, either through court victory for plaintiffs or US Congress taking advantage of equity markets to gradually 'sell' their 79.9% stake. If you remove all the lawsuits from the equation and remember the US Government needs private capital for mortgages to be funded and liquid in the US market, the need for the GSE's is substantial and thus private capital should be valued. Also, if you can get past the statements by Senate members against Hedge Funds profits and simply accept that the preferred stock and common stock would need to be honored as part of the corporate balance sheets, some hedge funds would make money but the US Government would recover multiples above any of these amounts recovered by shareholders. The value of the $143 Billion is well above total amount of the junior preferred securities face amount of $33 Billion; the exercise of these warrants may need to be done sooner rather than later in order to avoid declining US stock market valuations.

Whether the US Government chooses to continue to support or leave their involvement in the mortgage market, a market valuation of the equity stake at a 12-1 multiple provides significant return to both the US Government and private capital (common shareholders and preferred shareholders) and could go a long way towards the companies recapitalization.   If treated fairly, the current private capital shareholders would most likely put additional funds up to assist with a necessary recapitalization for future ongoing operation of Fannie Mae / Freddie Mac.  I don't believe that the US Government will walk away from their stake and neither should you.