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The "Oh Shit" Moment

posted by Adam Levitin

Today was the "oh shit" moment in the mortgage crisis. (Hey, this isn't a family-oriented blog...) Fannie Mae and Freddie Mac's shares crashed because of fears that they are overleveraged and even balance sheet insolvent on a mark-to-market basis. And the FDIC shut down IndyMac, the ninth largest thrift in the country, and the first major bank failure since the S&L crisis.

Sure, the Bear Stearns collapse was alarming, but its loss hasn't been felt by the economy. And IndyMac itself isn't going to pull down the deposit insurance fund. But the failure of Fannie or Freddie, much less both, would seriously harm what is left of the secondary mortgage market. Fannie and Freddie need to remain as viable as possible to prevent a further collapse in the mortgage market.

Unfortunately, there don't seem to be a lot of good options for helping Fannie & Freddie. They could try to raise more capital, but it's not clear that there is sufficient capital interested and available. Sovereign wealth funds would have a host of PR issues taking a large stake in a US government sponsored enterprise. Maybe private equity shops will jump in. Where's the Master Liquidity Enhancement Fund when we need it?

Perhaps Fannie & Freddie could get a sufficiently large and low-cost line of credit or guarantee from the Federal Reserve or the Treasury directly to shore up their capital position. That'll put taxpayers on the hook, but at least in a contingent way. This might be the best option, in that it could shore up the GSEs in the short term, but also force a longer term debate about why Fannie and Freddie still get to be both private and public simultaneously--capital markets and mortgage lending have evolved considerably since the creation of Fannie and Freddie, and the GSEs might have outlasted their original purpose of providing liquidity and geographic diversification in mortgage lending.

If Fannie and Freddie can't raise sufficient funds in the market or from the government, then they're looking at potential conservatorship. The decision rests with the director of the Office of Federal Housing Enterprise Oversight, not Congress, but is triggered by insufficient capitalization or likelihood of default (see 12 USC 4619 for details). But a conservatorship basically replaces the old management with new (likely government) management. It doesn't fix their balance sheets, and Fannie and Freddie's problem now isn't management. It's the market.

Likewise, the federal government could nationalize the companies. I'm not sure exactly how the mechanics of that work; the US Code provisions for GSEs provide for a conservatorship, not a takeover. Maybe this would happen through eminent domain, but that usually requires certain administrative procedures, which don't fit with a crisis. Or maybe the government would purchase a large enough position in the GSEs that it would end up the owner (freeze-out merger with the US government?). So much of the government experience over the last half-century has been privatizing, that I'm not sure who knows the legal mechanics of nationalizing companies in the US. (It might be time for a call to Presidente Chavez...). The problems with nationalization are pretty clear--huge addition to the liabilities column of the government and uncertain addition to the assets column, a combo that will likely increase the cost of borrowing for the Treasury, and force either higher taxes, decreased spending, or even greater deficits.

None of these solutions are great. The truth is that there isn't anything that can really fix Fannie or Freddie other than an improvement in the mortgage market. And that isn't going to happen any time soon (don't count on the FHA bill). We're looking at a bumpy landing....


That whirring noise that you hear whenever a stock ticker is flashed on a TV screen is the sound of the rotary fecal distributor getting up to speed, Professor.

I get the part about not being able to increase capitalization by selling new stock (though I could see some private equity funds thinking that a buy would look pretty good if they get a clear red light on conservatorship). What I don't quite get is the inability to attract investors for mortgage product. Granted, there was some serious oversaturation over the last five or six years the result of aggressive securitization of mortgage instruments. But now there is some serious undersaturation. I was struck by the fact that Fannie and Freddie both have default rates under 2%. I know they lack the market cap to cover these defaults in the event of a write off, but shouldn't there continue to be some appetite for more traditional loans? I mean 98% of their current portfolio is still performing, right? What am I missing here?

lmclark,I live in Sonoma county Ca.our median prices has dropped 33% YoY,june to june,and the local paper predicts a further 16% drop in the next year.I can get you a purchase money loan with 10% down at a little less than 7%,30 year fixed.As an investor looking at inflation and risk,is this where i want to put my $? 7% return IN DOLLARS for 30 years for a depreciating asset in a declining market? Granted most 30 year loans don't last that long for a variety of reasons,but The risk/return does not look attractive to me somehow...

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