Tuesday, July 15, 2008

Fannie and Freddie: an overview

Today's print edition of the Financial Times carried some excellent coverage of the ongoing crisis surrounding Fannie Mae and Freddie Mac.

Since their analysis is far superior to anything I could offer on the subject, I thought we'd take a look at what the FT has to say on the history of the two GSEs, current market sentiment towards the mortgage giants' shares and debt, and the likely outcome of any government "backstop" or bailout plans.

First off, John Authers and Stephanie Kirchsgaessner provide a bit of historical overview on Fannie and Freddie in their piece entitled, "Moral hazard on the road to increasing profits".

Here are a few key excerpts from their article:

"Many US economists, on the right and the left, are today able to say: “I told you so.” Few developments in US financial policy over the past half century have been more controversial than the decision to allow Fannie Mae and Freddie Mac to develop to their great size as private shareholder-owned institutions.

Fannie Mae (originally the Federal National Mortgage Agency) had its roots in New Deal legislation of the 1930s. It was set up in 1938 as a government-owned development bank. Its purpose was to ensure that mortgage interest rates would stay at low levels that kept home ownership within the reach of the US middle class.

In 1968, the decision was made to re-charter the FNMA as a private entity, funded entirely by shareholders. As it continued to operate under an explicit mandate from the government, however, the belief took hold that Fannie Mae enjoyed an explicit guarantee from the government.

The complaint was that private sector institutions could not possibly compete against a company that in effect held a government guarantee. To address this complaint, Freddie Mac (the Federal Home Loan Mortgage Corporation) was chartered in 1970, with a similar mission to ensure stability, liquidity and affordability, and to compete with Fannie.

But this did not quiet the objections. First, the existence of the agencies was held to create “moral hazard” – the mere presence of such a guarantee, it was held, would create an incentive for excessive risks. As it was obvious the government could not allow the agencies to go bust, capitalism’s normal controls against risk-taking would not work. "

Be sure to read the whole thing, as the authors explain the "crowding out" effect that the two GSEs had on the private sector's involvement in the US mortgage market.

"A history of Freddie Mac and Fannie Mae" provides a brief timeline spanning Fannie Mae's and Freddie Mac's initial chartering, up to their present difficulties, along with an easy to understand graphic on "How the US mortgage markets work". Very handy for quick reference.

In, "Effort unlikely to improve lot of homeowners", Saskia Scholtes describes how, "the US government's efforts to quell the crisis -surrounding Fannie Mae and Freddie Mac will affect different constituencies.". Read on for a concise overview of how forthcoming plans will affect homebuyers, debt investors, equity investors, and foreign investors.

Henry Sender describes how the focus of Wall Street's "take under" trade has shifted from Fannie and Freddie to the rest of the financial sector, as traders look to short banks and financial institutions who seem to be at risk of going under.

And lastly, Neil Dennis provides an update on how investors are reacting to proposed rescue plans for Fannie and Freddie in, "Ailing sentiment hits dollar and global stocks".

We'll have more on Fannie and Freddie in our next post. Stay tuned.