How Fannie and Freddie turned the US dream into a nightmare
Sub-prime lending crisis doomed two mortgage lenders
US Treasury Secretary Henry Paulson announced the nationalisation of Fannie Mae and Freddie Mac yesterday
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Monday September 08 2008
AS DANIEL Mudd walked into the downtown Washington DC offices of the Federal Housing Finance Agency (FHFA) at 2.50pm on Friday, the chief executive of Fannie Mae knew it was the beginning of the end.
Flanked by his own in-house lawyer, and by Rodgin Cohen, head of leading Wall Street law firm Sullivan & Cromwell, Mr Mudd was resolute.
Within 15 minutes, Jim Lockhart, head of the newly created FHFA, had begun to explain the process by which Fannie, along with younger brother Freddie Mac, would be nationalised. The process brings to an end a 70-year experiment that began as an attempt to get a struggling nation back on to its feet, and has ended in the largest takeover in history, with an unquantifiable cost to the US taxpayer.
The roots of yesterday's dramatic decision lie in the sub-prime mortgage crisis that has beset the US economy for the last 18 months.
Although neither Fannie nor Freddie owned or invested in sub-prime mortgages -- mortgages which were given to those with poor credit histories or those who could not confirm their income -- they have been tainted in a spectacular way.
Confusing
The essential but complicated role the pair play in propping up the American housing market is mired deep in US statute and the two companies' confusing articles of association.
But essentially, banks loaned people money for mortgages, the banks then sold on loans to Fannie or Freddie, which in turn packaged the loans into bundles to create bonds which external investors could purchase. This process worked relatively well for decades, with Fannie and Freddie's bonds perceived -- and therefore priced -- as US government bonds, because of a perception that there was some form of implicit guarantee in the way the companies were established that would not allow them to fail.
Whether such a guarantee ever actually existed is the subject of much financial debate -- complicated by the "government-sponsored enterprise" (GSE) moniker which is attached to the pair -- but when, in the last 12 months, investors began to stop investing in bond issues by the pair, the mortgage market began to seize up, making it more difficult and expensive for normal Americans to get a mortgage.
In spite of protestations from both companies that all was well, no one, and certainly not their largest investors which included the national banks of China and Japan, appeared to believe them.
As a result, shares in each company plunged more than 80pc in the last six months, while Fannie and Freddie were forced in recent weeks to pay record yields on relatively small bond issues simply to get them away as investors became concerned that there was a sizeable risk in buying such bonds.
As was the case in the near-collapse of Bear Stearns in mid-March -- the investment bank that was rescued by JP Morgan Chase -- in the end it was perception rather than actuality that crucially damaged the pair. Of course, by essentially bringing both institutions into the public sector, the Bush administration has closed off one set of problems, and opened a whole set of others.
The aim of nationalisation is two-fold. As GSEs, Fannie and Freddie had a limit as to how much they could borrow. Under FHFA control, the only limit on how much debt they can get into is the extent to which the US government can continue to borrow.
Secondly, the US Treasury hopes that, given the way it has structured the nationalisation, external investors will return to invest in Fannie and Freddie's debt issues, thereby easing somewhat the untold burden on American taxpayers.
The third conundrum in all of this, of course, is that this is an action taken by a lame-duck presidential administration, with less than four months of its second-term to go.
By the end of January, President George W Bush will be gone, and whoever replaces him will be left with a hefty burden.
Over the weekend, Barack Obama, the Democrat's presidential nominee, said that the rescue "must protect taxpayers" stressing that it was an "extremely serious" situation.
But ironically, the situation will pose more of a problem for John McCain, the Republican nominee and a relatively close ally of President Bush, who is an avowed believer in smaller government and lower taxes.
Expensive
Sarah Palin, McCain's vice-presidential running mate, said that Fannie and Freddie had "gotten too big and too expensive to the taxpayers," promising that if successful, she and McCain would make them smaller and smarter and more effective for homeowners who need help".
Whether such a prospect is possible remains to be seen.
"At Fannie Mae, we are in the American Dream business," the company has always boasted, until now. For the American people -- and whoever may lead them going forward -- the dream business has turned into a costly nightmare. (© Daily Telegraph, London)
- James Quinn
