US government discusses Fannie and Freddie bankruptcy

According to a Wall Street Journal report, the Treasury is concerned enough about the viability of Fannie and Freddie that they have discussed contingency plans in the case of potential bankruptcy.

Given the level of risk these two are taking on their poorly capitalized balance sheets in order to provide liquidity to the mortgage market, it is only a matter of time before the Federal government has to step in. Massive writedowns and the need to raise capital should be a foregone conclusion by this time. Without a Federal guarantee neither of these outfits is a AAA company.

The U.S. government had better think of a solution and get involved fast before the situation at Freddie and Fannie destabilizes the market any further.

U.S. Mulls Future of Fannie, Freddie Administration Ramps Up Contingency
Planning as Mortgage Giants Struggle
By JAMES R. HAGERTY, DEBORAH SOLOMON and DAMIAN PALETTA
July 10, 2008

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.

These discussions have been going on for months and are part of normal contingency planning that the Treasury Department and other financial regulators regularly undertake. The talks have become more serious recently given the financial woes of the shareholder-owned, government-chartered companies, whose stability is vital to the functioning of the nation’s housing market, these people say.

The government doesn’t expect the entities to fail and no rescue plan is imminent, these people said. Government officials and market analysts expect both companies will be able to raise large amounts of capital relatively easily. Treasury officials are nonetheless talking about what the government could — or should — do if Fannie and Freddie become so pressed that they are unable to borrow money and continue operating.

On Wednesday, Freddie shares fell 24% to close on the New York Stock Exchange at $10.26. Fannie shares dropped 13% to $15.31. For both companies, it was the lowest close in more than 15 years. Fannie’s share price is down 76% from a year ago and Freddie is down 83%.

The shares of the two companies have plummeted for several reasons. Investors are worried they will suffer bigger losses as housing prices continue to fall and mortgage defaults rise. Stock-market investors are also worried they will need to raise significant amounts of capital to cover those losses. For stock investors, that means the value of their ownership stakes in the company will be cut. Bond investors continue to lend to both companies, though they are also demanding slightly higher interest rates.

Fannie and Freddie’s decline helped drag the broad stock market into bear market territory Wednesday. The blue-chip Dow Jones Industrial Average, already in a bear market, tumbled 236.77 points, or 2.1%, to 11147.44. The Standard & Poor’s Composite Index of 500 stocks, which includes Fannie and Freddie, had hovered above the 20% decline that marks a bear market but broke through on Wednesday, falling to 20.5% below its peak, and to its lowest point since July 21, 2006.

Fannie and Freddie’s health is of deep concern to policy makers because of the critical role they play in the housing market. The two companies own or guarantee about $5 trillion of mortgages or nearly half of all U.S. home-mortgage debt outstanding. The government has increasingly leaned on the companies to provide critical stability to a housing market crippled by falling home prices and banks too nervous to lend.

If a loss of confidence among investors made it impossible for Fannie and Freddie to continue supporting the mortgage market, “the government would have to step in,” said Douglas Elmendorf, an economist at the Brookings Institution in Washington.

“They can’t be allowed to fail,” said Peter Wallison, a former Treasury Department general counsel. “The losses would extend through so much of our economy, and so much of the world economy. There is simply no way that the United States government can let it happen.”

Both Fannie and Freddie declined to comment on the government discussions.

It’s unclear what the government might do to either forestall or mitigate any potential problems. Treasury Secretary Henry Paulson has said in the past the government will not back the debt of Fannie and Freddie.

Options mentioned by analysts include a credit line from the Federal Reserve, an equity investment by the government or an explicit federal guarantee of the mortgage companies’ $1.5 trillion in debt.

The most likely scenario is that Fannie and Freddie will raise capital from private investors, even though that will dilute the interests of current shareholders, said Josh Rosner, an analyst at Graham Fisher & Co., a New York research boutique.

So far, the companies have been able to tap the credit markets at relatively low cost, despite jitters over their financial condition. On Wednesday, Fannie Mae issued $3 billion in two-year bonds that were priced to yield 3.272%. That was 0.74 percentage point more than yields on comparable Treasury bonds, more than double the gap between those two yields a year ago.

In case they are unable to attract sufficient private money, though, the government needs a contingency plan to shore them up, Mr. Rosner said.

“All the [regulatory] agencies are looking at what kind of actions may need to be taken,” said William Seidman, a former bank regulator who served as chairman of Resolution Trust Corp., an agency created by Congress to sell the assets of failed savings and loans in the aftermath of that late-1980s financial crisis.

Unprecedented Thinking

The current credit crisis has prompted some unprecedented thinking from national policy makers about how to maintain the integrity of the financial system. Since the near-collapse of investment bank Bear Stearns Cos. earlier this year, both the Treasury and the Fed have been pondering how to unwind a failed institution in an orderly way.

The most recent conversations have not only focused on Fannie Mae and Freddie Mac. Treasury officials have run through multiple different scenarios, including what would happen in the event of the failure of a big hedge fund or large commercial bank.

In addition, since the crisis struck last August, officials at Treasury, the Fed and other agencies have been discussing contingency plans known as “break-the-glass” ideas, referring to what takes place right before someone pulls a fire alarm. The plans were meant to prepare policy makers for the unlikely event of a broad financial crisis.

Any move to prop up the mortgage giants would likely set off a political firestorm. The two companies have long been a target for some Republicans who contend that Fannie and Freddie have profited from an implicit backing they receive from the government.

Congress created Fannie and Freddie to provide a steady flow of funds for home mortgages. Though the Treasury regularly states that the U.S. government doesn’t guarantee their debts, most investors believe the government would have
to bail the companies out in a crisis. This “implicit guarantee” allows them to borrow money at lower interest rates, only modestly higher than those paid by the Treasury.

The Bush administration has long worried about the risk posed by the companies, saying they have the potential to destabilize the entire financial market. The administration has been pushing for regulatory reforms to help mitigate the risk, including a new, more powerful regulator to oversee them. Congress is in the final stages of considering legislation to create that new regulator, which the Senate could pass Thursday.

On Tuesday, Treasury Secretary Henry Paulson said the best thing policy makers could do to restore confidence in the housing market would be to pass legislation overhauling supervision of the two companies. Mr. Paulson views the companies as crucial to housing and financial markets.

“What’s the No. 1 thing that could be done?” he said in a speech. “What’s the thing that will make the most difference? By far, by far it is the confidence that will be injected in that marketplace and the secondary marketplace through those institutions when reform is done.”

Constant Access

To continue bolstering the mortgage market, the companies need constant access to the debt markets. If investors suddenly decide they don’t want to buy the companies’ debt, the companies might have to unload some of their holdings, including mortgage-backed securities. Investors have already lost confidence in mortgage-backed securities other than those guaranteed by Fannie, Freddie and the Federal Housing Administration. A dumping of mortgage-backed securities would raise interest rates for people seeking home loans.

The Treasury has been worrying about such a dire scenario for years. In a 2006 speech, Emil Henry, then a Treasury assistant secretary, likened a failure of one of the companies to a “single gunshot setting off an avalanche.”

Fannie and Freddie have suffered combined losses of more than $11 billion in the nine months ended March 31. Analysts expect the toll to worsen as more homeowners default.

Defaults on loans owned or guaranteed by the two companies remain fairly modest but are rising quickly. Fannie has reported that 1.22% of the single-family loans it owns or guarantees were 90 days or more overdue in April, up from 0.62% a year ago. For Freddie, the delinquency rate is 0.81%, up from 0.49% a year earlier.

There is at least one precedent for the government making concrete a financial obligation that was previously only assumed. During the crisis caused by the failure of savings-and-loan institutions in the 1980s, Congress passed the Competitive Equality Banking Act of 1987, making the government legally liable for obligations of the Federal Deposit Insurance Corp. Congress had previously adopted a joint resolution that the government would support the deposit insurance fund if necessary, but the pledge wasn’t binding.

–Wall Street Journal, 9 Jul 2008