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Fannie/Freddie bail out

September 8th, 2008 10:17 PM by Lehel Szucs

The U.S. treasury announced yesterday that they will take over mortgage giants Fannie and Freddie effective immediately as a result of continued losses and market instability.
 
While on the surface this appears to be another sign of deteriorating market conditions, I view this as a very positive step towards ending the vicious cycle that we are currently in. The "credit crunch" is causing severe stress on too many sectors of the economy and there were no signs of easing.
           
While the Fannie/Freddie bail out will ultimately be the most expensive tax payer bail out of all time, failure to take these steps could have roiled the international economy and potentially devastated the U.S. Economy well beyond a recession towards a major depression.   Paul Volcker, whom I consider to be one of the best economist ever, said recently that this financial crisis "most complicated" he's ever seen.  “Losses will clearly exceed $500B and U.S. growth will be slowest since the Great Depression."
 
The decision to take over Fannie/Freddie will send a clear message to those that buy and hold Fannie/Freddie debt, currently to the tune of 5.3 TRILLION dollars, to calm down.  Concerns over the financial health and well being of Fannie/Freddie are laid to rest enabling investors to become much more confident and comfortable about their investments in Fannie/Freddie debt and allow them to not only hold the debt but continue to buy more.
 
Here is a simple explanation of how Fannie/Freddie work:  Every time Fannie/Freddie purchased a loan that was made by a bank or mortgage lender to a homeowner, that debt was packaged together and the payment stream of monthly mortgage payments made by you and I was sold to investors. The sale of those payments to investors created cash for Fannie/Freddie to go buy more loans from banks which would in turn go out and fund more loans to homeowners thus creating liquidity in the markets.  The key here is that Fannie/Freddie did not sell the actual home loans they purchased from banks.  They raised money buy selling debt (Fannie/Freddie IOU’s) to investors based on the mortgage payments that they were collecting from homeowners. 
 
With the current liquidity crisis, and the slumping housing market, Fannie/Freddie were having difficulty raising money to fund the loans they were buying because investors were becoming very concerned about Fannie/Freddie's ability to remain in business.  The thought process is very simple.  If Fannie/Freddie are not able to collect payments on the mortgages they have, how can they in turn make payments on their debts to us?  Not only were default rates increasing on the incoming payment streams but losses were mounting from bad loans that were purchased by Fannie/Freddie putting further strain on their ability to make payments on the trillions of dollars of outstanding debt they had outstanding.  
 
As a way to reduce their losses, both agencies used creative accounting tools to delay the reporting of their losses. One example of this was the recent change to their guidelines for reporting losses on a delinquent mortgage from loans that were 90 days delinquent to loans that are TWO years behind on their payments.  These creative accounting methods and continued reports of increased defaults was making it extremely difficult for Fannie/Freddie to maintain the confidence of the market investors who bought their debt. 
 
While the decision to take over the two mortgage giants will cause those who hold Fannie/Freddie common and preferred stock to get wiped out entirely as their positions are diluted, this should send a clear message to those who buy and hold the 5.3 Trillion of Fannie/Freddie debt to sigh a breath of relief as the U.S. Govt is now the debtor and sure to make payments on the debt.  This in turn should calm nerves and start to restore some liquidity back in to the market.   I also expect that this will cause mortgage rates to drop as the debt that's ultimately sold now is US Gov’t debt which should lower the cost as a result of a much stronger borrower than the previous Fannie/Freddie.
 
Imagine the turmoil that would have been caused within the housing market if Fannie/Freddie were allowed to fail.  Getting a home mortgage to buy or refinance would have become increasingly more difficult than it already is.  The global markets would have slowed dramatically causing catastrophic consequences.  Fannie/Freddie should have never been allowed to get to the size and scope that they did.  There was a fundamental flaw in their business model. None the less the decision to take them over was the right one even if at a very large cost to the taxpayer as failure to act would have resulted in much wider losses.
 
Posted in:General
Posted by Lehel Szucs on September 8th, 2008 10:17 PM

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