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By David Stevenson, MoneyWeek
14 July 2008
If you had to come up with names for some of the four horsemen of the financial apocalypse, you might opt for some grisly economic terms, like "inflation", or "depression". Or if you're of a more creative bent, you might opt for "hubris", or plain old "greed."
But whatever your literary preferences, it's probably fair to say that the names "Fannie" or "Freddie" wouldn't get a look in.
Yet fears that the two US mortgage giants, Fannie Mae and Freddie Mac, were on the verge of collapse has seen commentators shrieking about the end of capitalism as we know it. And perhaps they weren't far wrong.
The US government has been working on a bail-out for the companies all weekend, which it finally unveiled last night. But as usual, the government intervention is just storing up bigger problems for the future.
So what do Freddie and Fannie actually do? The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Corporation (Freddie Mac) were set up by the US government (Fannie in 1938; Freddie in 1970) to encourage home ownership.
They don't actually issue mortgages themselves. They buy or underwrite mortgages from commercial lenders such as banks. The commercial lender is then able to use the sale proceeds to write further mortgages. The fact that Freddie and Fannie took the risk off their books, also made lenders more confident about offering loans to borrowers who might otherwise have struggled to get one.
Where do Fannie and Freddie get the money to do this? They sell shares and raise debt by issuing bonds, exactly the same as any other company. Because Fannie and Freddie are seen to be backed by the US government (although it's important to understand that they don't actually have any kind of explicit government guarantee) they can raise the money to buy the mortgages cheaply.
So now they're very big players in the home loan game. Combined, the two companies either hold or guarantee about $5.3 trillion worth of mortgages, nearly half of the $12 trillion US home loan market. It was all nice and cosy until everything started to go horribly wrong in the American housing market.
Property prices have been dropping for two years now, and many mortgage borrowers in the States have now either got so far behind with their payments (more than 6% of all US mortgages are now in arrears), or given up altogether and have thrown the house keys back at the lenders, that Fannie and Freddie are now in serious "shtuck".
"The major issue is that these are very leveraged financial institutions, much more than any other bank, and they have lots of mortgage assets. As real estate values decline every day, the value of these assets are called into question," says Steve Persky of Dalton Investments.
Lehman Brothers reckon Fannie Mae needs extra capital of $46bn while Freddie Mac would need some $29bn. Sean Egan, head of credit ratings firm Egan Jones, thinks Freddie alone will need to find $7bn over the next six months due to write-downs and losses. Both firms have already cut their dividends to conserve as much cash as they can.
Former St. Louis Federal Reserve president William Poole has already called the two companies "insolvent", with Freddie owing $5.2bn more than its assets were worth in the first quarter. The trouble is, "if Fannie or Freddie failed, it would be far worse than the fall of Bear Stearns," says Egan, "it could throw the economy into depression or something close to it."
So the US government felt it had to do something, hence last night's bail-out. The two companies will be allowed to borrow money from the Federal Reserve, while the US Treasury will also be allowed to buy shares in the companies if necessary. There will also, in future, be a role for the Fed in regulating the "Government-Sponsored Enterprises" or GSEs.
But working on Sunday night is a sure sign of panic. And it looks like just applying sticking plaster when there's blood spurting everywhere. As Hugo Dixon puts it on Breakingviews.com, "there are poorish bailouts and bad bailouts." This "looks like a pretty bad one" Uncle Sam will be shouldering almost all the pain "it looks like the Bush administration, which for many years sought to pretend it was not providing a guarantee to Fannie and Freddie, has written them a blank cheque."
That's not a cheque that the US can afford. "The US government's own credit could be damaged by the bail-out," says Dixon. Fannie Mae and Freddie Mac might have been deemed too big to fail - but who's big enough to bail out the US?
When investors start seriously asking themselves that question, expect the dollar to plunge.
