The Fannie/Freddie Bail-Out: The Plan and Why Now?

It's official: the US government is bailing out Fannie Mae and Freddie Mac. Over the last 24 hours there have been a lot of stories and a lot of analysis of the situation. I would encourage everyone to read as much of this as possible; this is one of the most important developments in the financial markets in the last 30 years (if not the most important).

Let's go through some of the points in detail.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

In short, Fannie and Freddie will grow a bit and then become far more manageable from a size perspective. This is a very sound policy, if only to prevent a bail-out of mammoth proportions from having to occur again. It's important to note there is no mention of where the downsizing will end - that is, will Fannie and Freddie decrease the size of their respective portfolios for two years or ten? There is no firm answer to that. I suspect that no one really knows. Instead, the players will use a "wait and see" attitude regarding this whole mess.

Treasury has taken three additional steps to complement FHFA's decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders - senior and subordinated - and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

All this means is both institutions will issue a special type of security that will be sold only to the US Treasury. In return, the US Treasury will provide funding to keep Fannie and Freddie's net worth positive. In accounting parlance, this means both will have always have more assets then liabilities. This will prevent Fannie and Freddie from having to raise capital in the financial markets. Instead, they will simply go to the Treasury.

The implied understanding with this arrangement is the currently existing common and preferred shareholders will bear the brunt of the losses because the Treasury will have a superior claim on Fannie's and Freddie's assets. In short, common and preferred shareholders are left holding the bag at this point.

Back to the plan:

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Not only is there a preferred share program in place, the Treasury is also backstopping each agency with a secured lending facility. In other words, Fannie and Freddie can either issue equity which the Treasury will buy or get a loan from the Treasury. Either way, ample funding is available.


Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.

So, the US Treasury will now buy agency MBS securities. So, to review the plan, there are four parts.

1.) Shrink the size of Fannie and Freddie, largely through natural attrition of the mortgage portfolio 2.) Purchase special equity positions from Fannie and Freddie 3.) Offer a special line of credit to Fannie and Freddie 4.) Buy - on a temporary basis - agency MBS from Fannie and Freddie

Points 2 and 3 were specifically granted to the Treasury in the housing bill passed about a month and a half ago. At the time, Paulson said he had no intention of using either. I have not seen point number one mentioned at any time, but it does not surprise me. And point number 4 is merely an extension or enlargement of the current Federal Reserve lending program (one of the alphabet soups they initiated over the last year).

Why is this happening now?

There is also an interesting point mentioned in the Treasury statement: "as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free." Consider this in light of the following points from the blog, Angry Bear:

Now consider the following from MarketWatch,

"The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities.""

China alone holds $376 billion in bond holdings.

Unless I am misreading something, foreign central banks will be protected, including China's...and the America taxpayer will foot that bill.

Secretary Paulson has been busy of late reassuring foreign central banks that they will be protected.

"In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments.

In one such conversation, at the end of August, the Treasury sought to reassure the Bank of Mexico, according to a person familiar with the matter, of the soundness of agency securities held by the bank. Treasury officials have also had similar conversations with Japanese investors who are buyers and holders of agency debt."

Let me place this in perspective with the words of my friend New Deal Democrat over at Economic Populist:

6. Our new Chinese creditors have demanded their first payment. Several times in the last week, Chinese officials have stated in no unceertain terms that they would be VERY UNHAPPY if their Fannie and Freddie bonds weren't honored in full. Forget the Fed: US economic conditions are now dictated by the People's Bank of China.

The point of all this is clear. Over the last 8 years, the US has become extremely dependent on foreign financing for our way of life. Should this fall apart, we are in a world of hurt. As Angry Bear noted (same citation as above):

Yu Yongding, former advisor to China's central bank, put the matter bluntly:

`If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

Foreign central banks have been propping up the U.S. economy:

Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

The bottom line as to why this is happening is pretty clear: out creditors are getting nervous about the US's financial condition. They want to make sure they get paid. So Paulson and everybody else involved is making sure that happens.