Fannie & Freddie and the Banks

Financial market forces are bombarding us from all sides these days. We wish we were ambidextrous so we could write two articles simultaneously, one with each hand, to cover all that's going on. "Are you going to write about Fannie and Freddie and the banks?" Mother Crafton asked us the other day, when the Geranium Farm farm-hands gathered for an informal lunch. "Well, sure, but we also have to write about oil and speculators – we have to talk about everything!"

While we're anxious to write about oil markets, we'll address these big financial institutions first, since there are some thoughtless headlines running around the Internet about banks closing doors. Such notions way overstate the problems even as the problems are far from trivial. A big California thrift institution was taken over 10 days ago by the Federal Deposit Insurance Corporation (FDIC) in the biggest failure ever of one of those consumer savings associations. That same weekend, the Treasury and the Federal Reserve announced contingency plans to shore up the Federal National Mortgage Association (FNMA or "Fannie Mae") and the Federal Home Loan Mortgage Corporation (FHLMC or "Freddie Mac"). Are we supposed to be frightened? or are these really "bailouts" of politically connected investors?

Bad Mortgage Loans Continue To Inflict Pain
Mortgage delinquencies and foreclosures are still increasing and house prices are still falling. The bad loans are just modest fractions of overall loans, but there are so many more than normal that it is hardly surprising that some lenders are experiencing sizable losses. Indeed, IndyMac, the California thrift, specialized in subprime loans and its losses were bigger than most. It "failed" when depositors got scared and lined up outside its doors to take out their money; fortunately with our deposit insurance system, they are likely to lose little if any of their funds, and that bank re-opened after the weekend under FDIC auspices, even initiating a new program to help beleaguered borrowers try to avoid foreclosure. Importantly, while the depositors come out all right, the shareholders lose everything. They are not "bailed out" in the least.

Deposits Insurance Works;

Overall Banking System Is Sound
It seems to us that there are two important facts to keep in mind about the banks generally. First, as we note, nearly all individual bank deposits are fully insured, up to $100,000. Hardly anyone loses their money if a bank or thrift "fails". There are specifications on the $100,000 – it's a per-person limit, so if you have two accounts you're still only covered up to the one total. Make another account joint with someone else to double the coverage. Here's a link to a helpful article about this, http://www.walletpop.com/blog/2008/07/15/how-safe-is-your-money/?icid=200100397x1205902459x1200301280. ["Walletpop" appears to be a new blogsite associated with AOL's Personal Finance pages; we don't know more about it, but this article is itself thoughtful and clear. The FDIC's own website has good information too, of course, www.fdic.gov.]

The other fact to remember is that, despite losses by IndyMac and other big names in the business, the banking system as a whole is quite sound. There are about 7,250 banks in the country and 1,250 thrifts. In the first quarter, the FDIC classified 90 of these as "problems". In recent history, the largest number of problem institutions at any given time was 1,496 at the end of 1990; the smallest was 50 at the end of 2006. Of the 1990 problems, 382 of them "failed"; in 2006, there were no failures at all. Most currently, there were 3 failures during all of 2007 and 2 during the first quarter of this year. So yes, there are troubles, but the vast majority of them are overcome without federal assistance.

Fannie Mae & Freddie Mac Foster Nation-wide Mortgage Markets
What about Fannie and Freddie? These two big companies, founded and organized under Congressional charters, took their current forms about 40 years ago. Back then, home lending was localized. The thrift or bank in your neighborhood granted you a loan, which it added to its balance sheet. If the community was growing, the bank could keep lending. But suppose a local manufacturing company had layoffs, and the bank's deposit base decreased? Then it had to decrease lending, exacerbating the community's financial woes.

Fannie and Freddie were designed to ease these conditions by providing a conduit to national capital markets for the local mortgage loans. They buy loans from the local lenders using money they borrow from major institutional investors, including, among others, mutual funds and banks in other parts of the country. With their federal government charter, their debt is very highly regarded; even foreign investors get involved, including the central banks of other countries, looking to invest the dollars they hold in their foreign exchange reserves.

They Have Big Losses Too
These companies grew very rapidly, especially from 1999 through 2003, and then again more recently. They handle through direct ownership or "pass-through" arrangements, some 45% of all residential mortgages. The same delinquency and foreclosure issues have hurt their income, and they're also hurt by reductions in the values of securities in their internal portfolios. Consequently, Fannie Mae suffered an outright loss of $2.2 billion in the first quarter this year and Freddie Mac, $166 million. Both had had much larger losses in the fourth quarter of 2007. Investors are rightly dismayed by the losses and have driven the stock prices down sharply. Bond investors have driven up the interest rates they both pay on their debt. This has created a very sticky situation. These companies, though federally chartered, are privately owned – their stocks trade on the New York Stock Exchange – and they receive no government funding. They and the government are also clear that there is no government guarantee on their operations. But of course, the government "sponsorship" gives an aura of safety that has enhanced their status considerably.

What's a Treasury Secretary To Do?
Last week, Secretary of the Treasury Henry Paulson announced a contingency plan aimed at maintaining the flow of Fannie's and Freddie's business. The Treasury presently has authority to lend to them, but only a minimal amount. Paulson asked Congress for expanded lending ability and for the ability to make a modest ownership investment. As an addition to the present regulatory office, the Office of Federal Housing Enterprise Oversight (OFHEO, part of HUD), he requested authority for the Federal Reserve to exercise some regulation of them. Separately, the Federal Reserve Board voted to allow its system to lend directly to Fannie and Freddie, similar to the outreach it made in the spring to security dealers. [That facility, which ran as high as $38 billion in early April, has been virtually zero the last two weeks, a quite favorable sign.]

Is this a "bailout"? Is it "bad"? Technically, no, it is not a bailout. First of all it is a contingency plan and so far, nothing has happened. Members of Congress are jockeying with the politics of relevant amendments to legislation already in process. Apparently, neither institution has needed to borrow from the Treasury or the Federal Reserve. In fact, we should note that despite the plunge in their stock prices of late, both Fannie and Freddie have well above their legally required minimum capital and they have sizable amounts of cash to meet any liquidity need. On Thursday last, Freddie Mac, in a regularly scheduled auction, successfully sold $3 billion of its 2-year notes. The interest rate was somewhat higher than it has been paying, but bidding was strong and foreign bidders were as active as ever. Other data from the Federal Reserve shows that foreign central banks increased their holdings of Fannie and Freddie debt by $9.3 billion in the week before the auction, one of the largest weekly gains in recent months. These "official" investors own about one-third of Fannie and Freddie's direct debt. And again, shareholders have suffered dramatic reductions in the value of their ownership investment. They are surely not "bailed out".

So we argue that the Federal Government is trying to tiptoe through what amounts to a mine field here, putting out the word that it stands ready to lend support to these organizations it created and respecting a moral obligation for the benefit, not of private shareholders, but of the good faith of debt-holders, especially the foreign central banks.

Many argue that none of this does anything for homeowner-borrowers, just for the big investors. To the contrary, maintaining the flow and operation of these gigantic conduits for mortgage financing provides the most favorable environment possible for borrowers, troubled or healthy, in these volatile times. I don't even want to contemplate an alternative scenario.

Even after this long article, we are hardly finished with these issues. For instance, Mother Crafton also wants to know about "moral hazard". An intriguing phrase, isn't it? Stay tuned; more to come . . . .