Ruin of Modern Finance: Freddie and Fannie

In the late 1990s Freddie Mac and Fannie Mae moved into buying mortgage-backed securities issued by others institutions. Freddie and Fannie used their cheap financing to buy higher-yielding assets. In 1998 Freddie owned $25 billion of securities outside of mortgages. By the end of 2007 Freddie owned $267 billion. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. The industry has learned that AAA-rated securities have not been properly rated. In fact, the Congressionally-mandated powerhouses picked up a substantial amount of subprime securities because of faulty ratings.

Sometimes the mortgage companies went against charter and bought each other’s debt to keep the system working. This shored up a failing system hidden by short-term profits. Although this boosted short-term profits, this action was not in the original purpose of these organizations.

Fannie and Freddie were buying 50% of all mortgage-backed securities backed by conventional mortgage lenders in some years. This left the institutions exposed to subprime assets because of faulty and fraudulent ratings. At the end of 2007, Fannie had pre-tax losses of this type of $4.8 billion, while Freddie’s amounted to $15 billion.

The companies have also been unwilling to accept lower market prices in acknowledging delinquent loans. When borrowers fail to keep up payments on mortgages in the pool that supports securitized loans, Fannie and Freddie must buy back the loan. That action requires an immediate write-off at a time when the market prices of these loans are under continued downward pressure. In many cases, the wonder institutions have opted to pay interest into the securitized pool to keep the loans current creating a unique kind of fraud on the industry. The resulting fraud on the public and on the market is significant, only delaying the inevitable.

They also insured portfolios. This risk caused Freddie and Fannie to take huge positions in the derivatives market, in the middle of an accounting scandal. Fannie and Freddie also provided insurance against borrower defaults when the home buyer lacked a proper deposit, while taking on the risk of the insurers as well, in effect, burning the financial candles at both ends.

At the end of the first quarter of 2007, the two companies exceeded their minimum capital requirements by $11 billion apiece. The regulator declared that Fannie would have to lose $16 billion of capital and Freddie $14 billion for the government to be on the hook for losses. There are no depositors, only investors through the stock market, all backed up by the Federal Government. Each had ratings-related write-downs of between $5 billion and $6 billion last year, taking a huge cushion of capital out the door. Other losses ensued.

Stock market investment began to drop through the floor as investors declared their independence. Nevertheless, hope springs eternal. If confidence can be restored, Fannie and Freddie might survive without needing a bailout as market conditions are improved.

The federal government wants to avoid a bailout, requiring the U.S. taxpayer to bail out the whole grand scheme and posting the huge loss on the national debt, effectively doubling it. The assets being held aren’t liquid enough in a contracted market. With the mortgage housing crisis, Fannie and Freddie have become more important than ever, financing the majority of mortgages this year. They will need to keep lending to keep the mortgage system afloat. What is worse, these institutions cannot sell their portfolios of mortgage-backed securities. The market for these securities is non-existent. The government is caught holding the whole ball.

Insurance for the FDIC can handle some trouble, but not a substantial amount. As a result, the taxpayer is on the hook for a sudden rash of banking collapses. With downward pricing pressure on homes, the government losses on bank accounts while supporting an already bankrupt retirement fund insurance system, the government is close to being in an unfavorable position resulting in a resounding financial collapse.