Where there is crisis, there is also opportunity. The turmoil afflicting parts of America’s giant residential mortgage market has already claimed dozens of casualties, including two Bear Stearns hedge funds that bet the wrong way on structured products backed by loans to subprime borrowers. But Fannie Mae and Freddie Mac, the government-chartered siblings that tower over the market, spy gold in the rubble — or at least a chance to polish their tarnished reputations.
Founded to promote affordable housing, Fannie and Freddie make life easier for lenders by buying their home loans and packaging them as securities, or by guaranteeing third parties’ issuance of mortgage-backed bonds. Between them they hold or support assets worth more than $4 trillion. It was, therefore, no trifling matter when they were found to have misreported earnings in 2001-04 — by a combined $11 billion. Top executives were jettisoned, huge fines imposed, and the pair were hit with portfolio caps and higher capital requirements.
The journey to redemption has been backbreaking. They have spent billions of dollars on new systems and controls. At one point, more than 60 “restatement teams” were beavering away at Fannie, trying to make sense of its labyrinthine books. Their work is finally paying off. Fannie said recently that it will return to timely reporting next spring, earlier than expected, while Freddie will do so this year. The surprise lifted Fannie’s shares, which are up by around 13% this year.
Fannie and Freddie also hope to regain credibility by portraying themselves as buyers of last resort in the subprime market, as private lenders belatedly tighten standards and investors run from toxic mortgage-backed debt. They have pledged to buy tens of billions of dollars of new subprime mortgages, and are working on products to alleviate the plight of the worst-hit borrowers. As a result, their market share has grown in recent months, though not quite to the level it was at before the scandals. Remarkably, Fannie’s portfolio grew at an annual rate of 14% in May. The news this week of problems at another group of hedge funds where subprime bets turned sour, run by United Capital, is likely to send more business their way.
Some question the motives of the so-called government-sponsored enterprises (GSEs), accusing them of using the crisis to cherry-pick the best subprime customers without taking much extra risk. “They paint themselves as saviours, but they are essentially opportunists,” says Bert Ely, a consultant and long-time critic of the pair.
But with Congress having declared war on “predatory” lending, the move is politically smart. Nor can anyone deny that Fannie and Freddie are well placed to take a lead. Sentiment has swung quickly away from exotic adjustable-rate mortgages towards the safer fixed-rate products that are their bread and butter. And because they were forced to show restraint while others grabbed every bit of business going, their portfolios have plenty of room to grow. James Lockhart, the director of the Office of Federal Housing Enterprise Oversight (OFHEO), the GSEs’ regulator, sees it as an opportunity for them to educate the market in sound underwriting.
This is a time when Fannie and Freddie can prove their worth as market stabilisers, argues Patricia Cook, a senior Freddie Mac executive. And because the lack of liquidity that comes with instability means higher spreads, they should be able to meet the mission in their charters (to provide liquidity, stability and affordability) while also pleasing their shareholders. “Sometimes it’s a very elegant model,” she says. Analysts agree: they have been raising the GSEs’ price targets.
But not everyone is so sanguine. Though they do not engage in subprime lending, Fannie and Freddie hold large piles of bonds linked to such mortgages, some of it packaged externally. A small but significant share of this “private label” paper is rated below AAA, the top notch. In a recent report, Federal Financial Analytics, a consultancy, noted that a 15-30% writedown of this non-AAA slice—hardly inconceivable given the continuing rise in subprime delinquencies—would result in losses of up to $3 billion for Freddie and $3.6 billion for Fannie. That would knock back their return to financial normalcy.
This kind of analysis sets pulses racing at the Treasury, where officials worry about the threat the GSEs pose to the broader financial system. The problem is not just their size. The implicit government guarantee they enjoy, thanks to their charters, means they can borrow at rates close to those on risk-free Treasury bonds, whatever their financial state. This encourages them to grow recklessly. Mr Lockhart points out that between 1990 and 2005 their portfolios grew tenfold. American GDP doubled over the same period.
If Fannie or Freddie were to get into serious trouble, taxpayers would be on the hook for huge amounts. Worse, banks would be severely hurt, since they are allowed to hold as much of the two institutions’ debt as they want. Thousands do. Many hold more GSE paper than they do regulatory capital. This raises the spectre of a broad financial crisis if either of the mortgage giants were to collapse.
That seems highly unlikely at the moment. Indeed, as Brian Harris of Moody’s points out, even without their implicit guarantee Fannie and Freddie would be among the most highly-rated financial institutions. And yet things can change quickly: Fannie, remember, fell into technical insolvency in the 1980s, not long after having been in apparently fine fettle. This is why the Treasury, OFHEO and others are urging Congress to pass a bill that gives the currently feeble regulator similar powers to those of bank supervisors.
The GSEs seem unworried by the prospect of more stringent regulation. Deep down they are probably more concerned about threats from new forms of competition, such as covered bonds (on-balance-sheet instruments that enjoy a AAA rating because they are well collateralised) and home-loan securitisation trusts, which serve groups of banks. These innovations, as well as an increasingly liquid secondary market when times are good, could allow commercial banks to muscle in on the GSEs’ turf. Fannie and Freddie should enjoy their subprime bounce while it lasts.