Breaking News: Fannie and Freddie Face Imminent Conservatorship

As I have previously discussed, Fannie Mae and Freddie Mac, the two giant government sponsored enterprises (GSEs) that hold or guarantee over $5 trillion (or almost half) of the nation’s mortgages, have been seeing their capital reserves depleted as housing prices have been falling across the nation.  Well, tonight, things have hit point critical, and news is being released that the executives of both GSEs are being told that the government is preparing to place the two under government control, or conservatorship.

I’m going to try to explain the full scope of what is happening here, so please bear with me if some of it seems too simplistic.

Like all companies, Fannie and Freddie have shareholders.  They have a board of directors that make decisions for the company (on behalf of the shareholders) and executives that run the day to day operations of the companies.  Fannie and Freddie also have creditors.  In their case, these creditors are bond-holders who bought bonds issued by Fannie and Freddie (called “Agency Debt”).

Now conservatorship is somewhat akin to corporate reorganization (a form of bankruptcy), except that the reorganization decisions rest in the hands of the government instead of remaining in the hand of the company and its board of directors.  Now, in reorganization, the company has not gone into bankruptcy, in which case the shareholders get “zeroed out” (their shares become worthless), and the assets of the company are left to be divvied up by the creditors.  The company is dissolved and ceases to exist.  Typically, in a reorganization, the shareholders of a company will lose much and maybe all of the value of their shares, there is some negotiations with the creditors of the company (for example, maybe giving the creditors shares in the post-reorganized company) but with the full intention of the company surviving to see the other side of the reorganization.

The problem that makes Fannie and Freddie so bad is who the creditors are.  The $5 trillion dollars worth of mortgages that Fannie and Freddie own or guarantee had to be bought or backed with real money. Very little of Fannie and Freddie’s money has come from its shareholders.  Most has come from the Agency Debt that they have issued.  This debt has been spread far and wide.  Much of the Agency Debt has been bought by foreign governments.  China alone holds $376 billion of Agency Debt, and the total foreign holdings of Agency Debt tops $1.3 trillion.  The remaining Agency Debt is spread among all kinds of private financial institutions, including pension funds, mutual funds, municipalities, and banks. 

What has happened over the past month is that some of the holders of the Agency Debt have started to dump them in the open market.  (In the financial world, debt itself is sellable.  For example, suppose A holds a $100 IOU from Fannie due next year. If A gets into trouble and needs cash now or, in our example, no longer trusts Fannie to pay that $100, it can try to sell off that IOU to someone else.  And someone, like B, might be willing to pay $50 for that IOU, which means he thinks that there is, roughly speaking, a 50% chance that Fannie won’t pay that IOU.)  For example, China reduced its holdings of Agency Debt of $4.6 billion.  And there are rumors that Korea might do the same, in order to prop up its faltering Won.

When Agency Debt starts being dumped, its “value” plummets.  That may seem like no big deal to us because, hey, that IOU is still outstanding at its face value, but it has lots of financial implications.

For example, the commercial banks in America, the kind of banks that you and I deposit our money in, also have capital requirements.  Typically, this means the bank has to hold, in liquid assets, a certain % of their total deposits.  One of the liquid assets that the bank can hold is Agency Debt.  When the value of the Agency Debt drops, the bank can start to fail its capital requirements.  When this happens at the same time that the bank starts having non-performing loans, not only does this lead to the bank failing, but also to the FDIC (the Federal Deposit Insurance Corporation, the government corporation that insures that depositors will get their deposits back from member banks), incurring large losses.

Today, federal regulators shut down Silver State Bank [the son of Senator John McCain sat on its board until recently and was a member of its three-person audit committee, which was responsible for overseeing the company's financial condition] and the FDIC is estimating a $450 to $550 million hit to its reserves.  The FDIC has an insurance fund of $45 billion, but banks are failing fast, and its “watch list” of problem banks has just grown to 117 from 90.  Nine banks have failed so far this year, but the number is expected to climb to 100 by the end of 2009.  The FDIC will most likely have to find ways to supplement its insurance fund.

The terms of the Fannie and Freddie conservatorship have not yet been revealed, and there are conflicting accounts.  The NY Times is reporting that the common AND preferred shares will be reduced to nothing, but the Agency Debt (which, remember, the government has all but guaranteed) will be protected. The Washington Post is reporting that the common shares will merely be diluted and not wiped out, with preferred shares and debt protected. 

If something is protected, it means that the Agency Debt or shares will have to be paid out at face value.

While in conservatorship, the government will figure out what assets are actually left in Fannie and Freddie.  Whatever shortfalls there is between the assets and the protected debts and shares (which need to be paid out) will have to be made up by the U.S. government.  It is expected to be hundreds of billions of dollars.  And since we already run a current account deficit, it actually just means that we will have to borrow, from China or the Middle East or Russia, to pay off the Fannie and Freddie debts that we owe to China or the Middle East or Russia.

Yes, Fannie and Freddie are being nationalized.  It will likely happen before this weekend is up.  This is not democrats scheming for a bigger government.  THIS IS A REPUBLICAN ADMINISTRATION FORCED INTO IT BY UNSCRUPULOUS FINANCIERS.

I have laid out everything I know about this situation out here for you.  I’m not being snarky, or partisan, or trying to distort things.  You can try to look for one, but there is no liberal bent here. 

I believe that Senator Obama knows this is going on.  He not only understands it, but he understands the gravity of it.  He may not have a solution for the problem, but he will have the capacity to face it.  Unfortunately, I do not believe that Senator McCain has even the faintest idea of what an Agency Debt is. 

Please, I implore any on-the-fence reader that has made it this far.  This is real.  This is now.  And you must think about which leader you think can get us to the other side of this when you are voting in November.

Kady apologizes for wonking out here, but not over at her personal blog, Wonkess.

Comments

[Fairly Odd Mother]

Friggin' scary stuff. Thanks for a great explanation.

[jaelithe]

My husband thanks you for covering this. He has been freaking out over the fact that there has been practically no coverage of this on mainstream television.

This is a serious, serious problem and people need to pay attention.

[cynematic]

That smell you smell? Rubber, hitting the road.

No wonder Wall Street's panicked. "Too Big To Fail" might actually be tested. And no one wants to see that.

Me, I have my money in a credit union whose financial health and exposure to dicey loans I checked at http://webapps.ncua.gov/ncuafpr/. Accounts are insured by NCUA up to $100,000, (just like FDIC), and up to $250,000 for IRAs.

It's not failproof, but at least I feel the excesses of for-profit banks are checked somewhat by the not-for-profit charter of a credit union. And as a shareholder/member, I have some say in the direction of my credit union and my due diligence into its board gives me a greater sense of control over where and how safe my savings are.

[Donna]

Those of us whose eyes glaze over at the sight of figures thank you for being simplistic for us. NPR IS covering this, as are the papers. But I needed you to help put it into context. It does make me wonder about whether Fannie and Freddie should have been somewhat privatized in the first place -- or at least, that there should have been more Federal oversight (as with the entire industry).

[Daisy]

Does Phil Gramm think Fannie and Freddie are whiners? After all, according to him, there is no recession.

[Kristin]

What? Real news, about real issues? But haven't you heard that Sarah Palin may have had an affair???

Seriously, thanks a lot for this information...it's nice to get back to reality.

[LizP]

An excellent reminder that John McCain admitted that he is "weak" on economics. Thanks for a great basic explanation on the problems with Fannie & Freddie!

[Nicole]

I'm going to say something that seems overly simplified: This Is Bad.

And even if this started before 2000 - I still blame the Bush Administration. They are inherently myopic in their vision.

[Ricke]

What happens to the CEO of both companies? If they are forced out, do they still receive all the bonus packages?

[const]

thank goodness obama wasn't in charge as this is all going down. The democrats in congress have proven to be inept in face of this crisis. How a community organizer would handle the complexity of the current financial crisis should scare all of us.

More and more, I am leaning towards voting for McCain. He's the only one who actually works both sides of the aisle. With the democrats, we all have to admit, it's all about holding photo-op grandstanding hearings while blaming the "evil" bush administration. I think we need responsibility and ideas, not finger pointing.

[home buyer]

"Fannie and Freddie play a central role in our housing finance system and must continue to do so in their current form as shareholde­r-owned companies. Their role in the housing market is particular­ly important as we work through the current housing correction­. The GSEs now touch 70 percent of new mortgages and represent the only functionin­g secondary mortgage market. The GSEs are central to the availabili­ty of housing finance, which will determine the pace at which we emerge from this housing correction­. ...

OFHEO has reaffirmed that both GSEs remain adequately capitalize­d. At the same time, recent developmen­ts convinced policymake­rs and the GSEs that steps are needed to respond to market concerns and increase confidence by providing assurances of access to liquidity and capital on a temporary basis if necessary.­"