Fannie Mae and Freddie Mac - Flattened by the Credit Crunch?
Joe Buyer and his wife Kim Buyer have a kid and want a new house to raise a family. On a Tuesday afternoon they meet with their local bank’s loan officer, who stamps his approval on a mortgage that Joe and Kim may or may not be able to afford. The loan officer forwards the loan to his bank’s treasury department, which eventually flips the loan to the Federal National Mortgage Association (affectionately known as Fannie Mae). The cash proceeds from the sale of the loan are used to make more loans to other Joes and Kims. The profits from all of these loans are used to purchase “safe and stable” investments—like Fannie Mae preferred stock.
We all know the not-so-storybook ending to this scenario. What was once a win-win for all involved parties (new house, soaring profits, high stock price, great CEO bonuses) has now turned into a situation where literally everyone loses (no house, no profits, crashing stock, CEOs fired). With the recent announcement that the United States Treasury has taken over Fannie Mae and its fellow Government Sponsored Enterprise (GSE), Federal Home Loan Mortgage Association or Freddie Mac, hopefully this tragic tale can find somewhat of a bitter-sweet twist!
Though most view the bailout as a positive (stock markets around the world soared on the following day), there are bound to be casualties. Those hit hardest will likely be smaller regional banks, with large percentages of capital tied up in Fannie and Freddie preferred stock.
Community and Thrift Banks across the US – like Midwest Banc Holdings, Gateway Financial and Cascade Financial, names that many of you may not recognize or read about in prominent newspapers - all hold millions in Fannie and Freddie preferred stock. The value of these preferred securities is now a fraction of par and financial institutions that hold Fannie and Freddie preferred stock will likely be forced to take a large impairment charge. The US Treasury and Federal Reserve have hinted at some sort of support for Capital Restoration (through the now famous "back-stop" mechanism), but that is probably not going to happen without a lot of debate and pain to the tax-payer! The dénouement of the Fannie and Freddie tale is going to be played out across the smaller towns and communities of the US, where Regional Banks and Thrifts form the bulwark of the local economy.
Cut to Wall Street: For a large bank like JP Morgan Chase this isn’t a big deal, projected write-downs are only about 5%-6% of the investment bank’s estimated 2009 profit-per-share. But, for a smaller bank that doesn’t have a comparable capital base, a large write-down can be a crippling blow. Analysts believe that many smaller banks will have to raise capital, and some may even be forced to find a buyer.
In hindsight, many of these problems could have been prevented through specific interventions by the Risk Management function at Banks and Financial Institutions. The US subprime crisis, arguably, has its roots in deteriorating underwriting standards. It was exacerbated by lax credit risk measurement for retail mortgage lending (if you are the analytical type, read a related article that I had co-authored last year as part of FINsights, Infosys' Journal of Thought Leadership for Banking and Capital Markets). Better and robust risk management systems and processes will need to be implemented on priority across Regional Banks in the US. While Basel II touches the top dozen or so Banks in the Country, it is probably relevant to cascade down appropriate flavors of the Regulation to the smaller entities as well. Above all, there is that element of folksy, old fashioned common sense that needs to be brought to bear in good measure, while lending – always keep a safe margin on the collateral that is being provided!
Fannie and Freddie themselves needed to have focused on managing risk exposures better, given their GSE mandates. There are various theories out there about how they could have stayed much "lower on the risk curve" by sticking to their core and guaranteeing mortgages without necessarily owning them – but enough has been said over the past 48 hours or so since the storied "bail out"! Do you think the US Government takeover of Fannie and Freddie is a step in the right direction? I would love this debate to continue and look forward to your comments.
Comments
I still think this is the only step possible by Fed to stabilize the housing market; to generate liquidity in the secondary market.
The financial crisis that started as a sub prime related issue is now spread across all financial spectrum like Alt-A,CDS and all types of mortgages to name a few.Fed has to intervene somewhere to stop the avalanche effect that will impact the all financial markets across geographies and make recession more deeper/longer.
Posted by: Kannan | September 11, 2008 06:10 PM
There are several participants who should have used "folksy" common sense:
1. Joe and Kim who probably had bought a 5 bedroom home with a 3 car garage when all they could afford was a condo - in the hope that the price of the home would increase and they could flip it. And they bought this on a ARM with Interest only payments.
2. The Mortgage Banker who approved the loan knowing that they would not be able to pay in a year's time.
3. The Credit Rating agency who assigned a investment grade rating to the MBS/CDS/CDO's that were backed by this kind of debtor..looking purely at historical information (in many cases not even understading the structures CDO Cubed?!)and just because someone was paying them a ton of money to do it (I happened to interview a senior analyst at one of these firms).
And the tax payer pays for it through the Fed on the one hand with 401K values tanking on the other.
I think the RBI/SEBI are looking very smart at this point. And so is Bear Sterns (hey we got here first!).
The fun is only beginning..
Posted by: Sanal | September 19, 2008 09:01 PM
So far, US has been a market driven capitalist economy. Everything was going right before this financial crisis.
3 investment banks went kaput before final 2 standing surrendered to govt.
Though investment banks should be punished for their greed and Govt did rightly so with Lehman. But I think that in the bigger interest of common Americans, who have invested in stocks and loans, recent 700 billion dollar bailout will be a breather.
I hope 700 billion is used for the purpose it is supposed to rather than for lobbyists and supporters.
Posted by: Ashutosh Sharma | September 23, 2008 03:27 AM
The severity of the problem is getting worse, as rightly pointed out in this article.
It's not limited just to Subprime housing crisis,the friction we have seen is all across- from mortgage originator to investment banking business.
If we see the whole thing, it started from greed where every sufferer wanted to take off from something big.It started with predatory lending to predatory borrowing.
Coming to the point, whether it was a right decision of Govt to takeover Fannie Mae and Freddie Mac or not brings a lot of issues.
1)Fed can't let it go further to worsen the economy. As the people of America have lost faith after the crisis, Govt can't just be a spectator.
2)The logic was totally different when these two organizations Fannie Mae and Freddie Mac were formed in 1938 and 1970 respectively. But to attain a leap in value these two organizations forgot the risk-reward proposition. And it was the right time when govt again came up and showed its responsibility to save the whole housing turmoil happening in the US.
Posted by: Amit Gupta | October 3, 2008 06:50 AM
The US financial institutions made one fatal asumption: The price of an asset will increase infinitely.
This assumption is killer when lending is asset price based and not 'buyer's cash flow based'.
This fundamental flow coupled with decreasing Capital Adequacy Ratios (Were the regulators sleeping?) did the trick.
This whole failure points to one big question: Is capitalism nothing but human greed and hence, can't survive on its own? As we are seeing, capitalists are running for socialist protection from government.
The world over regulator authorities have to define risk recognition, risk measurement and risk mitigation guidelines from this perspective.
This has broken one more myth: Too big to fail. Wrong, the bigger it is, more it is capable of spreading systematic risk and putting tax payers money to line to mitigate the risk.
Posted by: Santosh Singh | October 15, 2008 04:15 AM
I've heard one conspiracy theory circulating: that the regional banks wouldn't have gotten into this mess if the federal regulators or liberals didn't strong arm them to buy Fannie Mae securities. What a bunch of bull. We should be pointing the finger at the rating agencies who gave Fannie strong AAA+ ratings at the time. any thoughts?
Posted by: johnny b | October 23, 2008 05:08 PM
The main issue behind the crisis is that the US government prints currencies in excess of gold reserves and distributes to sub prime lenders. Never in India is a loan offered to sub prime lenders.
Posted by: Indiainfraguru | October 30, 2008 07:13 AM