Fannie, Freddie, and fears of a market meltdown
Concerns about the financial stability of Fannie Mae and Freddie Mac have sent shares of the two companies plummeting by around 75 percent in the past year. Now many investors are wondering if the companies may need a bailout by the federal government—a move many industry analysts say would be disastrous for the world’s financial markets. So, how did we get here?
The early days of Fannie and Freddie
The Federal National Mortgage Association (FNMA) and the Federal Home Mortgage Corporation (FHMC), usually referred to as Fannie Mae and Freddie Mac, make and guarantee home loans.
Fannie Mae was founded in 1938. In the wake of the Great Depression, the housing market collapsed and private lenders were wary of making home loans. Franklin Delano Roosevelt’s New Deal designed Fannie Mae to save the mortgage market by providing local banks with money to finance home loans.
In its early days, Fannie Mae operated much like a national savings and loan. In 1968, President Lyndon B. Johnson privatized the company in order to remove it from the national budget, a move that was most likely the result of fiscal pressures created by the Vietnam War.
At that point, Fannie Mae began operating as a government-sponsored enterprise (GSE), a private company owned by shareholders and listed on a stock exchange, but at the same time financially protected by the federal government.
In 1970, to prevent it from becoming a monopoly, the federal government created another GSE, Freddie Mac.
Today, Fannie Mae and Freddie Mac buy home loans from lenders, then hold them in their portfolios or repackage them into bonds called mortgage-backed securities.
Fannie Mae and Freddie Mac make money, primarily, by charging fees on the loans they repackage into mortgage-backed securities. Purchasers of these securities pay these fees in exchange for a number of risks that Fannie Mae and Freddie Mac take by buying the home loans. Perhaps the greatest one is credit risk, the possibility that the borrowers of the underlying loans will default. In essence, Fannie Mae and Freddie Mac guarantee that the principal and interest on loans underlying their mortgage-backed securities will be paid—even if the borrower defaults.
As GSEs, Fannie Mae and Freddie Mac have a myriad of government protections, perhaps the most notable of which are access to a line of credit through the U.S. Department of Treasury and exemption from Securities and Exchange Commission (SEC) oversight.
A problematic history
Throughout the years, the companies’ exemption from SEC oversight has been of great concern to many investors due to the significant role Fannie Mae and Freddie Mac play in the nation’s—and even the world’s—economy.
Fannie Mae and Freddie Mac are the nation’s largest buyers of home loans. Together, they own or guarantee about $5 trillion of mortgages, close to half the mortgage market. Because they promise to step in and make good on their loans if the homeowners default, the companies guarantee trillions of dollars worth of loans, making them major players in the nation’s housing market.
At the same time, the companies’ status as GSEs—and their exemption from SEC oversight—means that they are not required to report to the public any financial difficulties that they may have. They are the only two Fortune 500 companies with such a privilege.
Together, those two factors worry many investors, because if one of the companies should experience difficulty—or worse yet, collapse—it’s possible that no one would know until it was too late. That could be disastrous for their shareholders, for obvious reasons—but also for the entire credit market. The U.S. government does not explicitly back Fannie Mae and Freddie Mac and the mortgage-backed securities they issue. Any possibility of their failure would likely lead to a meltdown in the world credit markets; if their guarantee is deemed worthless, millions of people worldwide who hold their mortgage-backed securities would panic, try to sell, and ultimately lose money.
As a result, the investment community generally agrees that the federal government will not allow the collapse of Fannie Mae and Freddie Mac. Moreover, if the federal government takes over the companies, U.S. taxpayers could be on the hook for hundreds of billions of dollars.
While these fears may seem extreme, they are not completely unjustified, as the companies have been plagued by scandal throughout their history. For example, in 2003, Freddie Mac revealed that it had understated its earnings by almost $5 billion—and was fined $125 million. And in 2004, Fannie Mae was investigated for widespread problems in its accounting practices, including shifting losses so its senior executives could earn generous bonuses.
Recently, worries about Fannie Mae and Freddie Mac have increased due to the state of the housing market. Before we explain why, let’s look at the history of the subprime crisis.
The subprime crisis
From 1998 though 2005, nationwide housing prices rose at an average annual rate of around 7.25 percent or 10 percent, according to the two most widely cited measures of housing prices, the Office of Federal Housing Enterprise Oversight (OFHEO) Index and the S&P/Case-Shiller (S&P/CS) Index. Even more dramatic numbers were seen during the last two years of the housing market boom, 2004 and 2005, when the OFHEO Index rose 9 percent per year and the S&P/CS Index rose more than 13.5 percent per year.
As a result, from 2004 to 2006, everyone wanted to get in on the action, including borrowers who could not qualify for traditional mortgages. These borrowers were everywhere, of course, but the most notable concentration was in the Sunbelt states and the upper Midwest. The Sunbelt states—Arizona, California, Florida, Nevada, and Texas—had booming real estate markets, and non-traditional mortgages helped borrowers afford larger homes by offering lower payments. In the upper Midwest states—Illinois, Indiana, Michigan and Ohio—housing prices were not rising significantly; however, deteriorating labor market conditions (such as in the automotive industry) created a number of borrowers who could not qualify for traditional mortgages.
In response to this demand, lenders made credit available to these borrowers. Rather than getting traditional mortgages, borrowers took out subprime mortgages, given to those with questionable credit histories—and Alt-A mortgages, to those without documented income. These mortgages also had a number of features designed to keep monthly payments low. For example, the commonly used 2/28 adjustable rate mortgage (ARM) had an initial interest rate set for the first two years and a floating interest rate thereafter. There were also interest-only mortgages, negative-amortization mortgages, and—something that may seem bizarre as we look back—option mortgages, which allowed the borrower to decide how much he or she wanted to pay each month.
Lenders and companies, Fannie Mae and Freddie Mac among them, took these subprime mortgages, and, as they did with all mortgages, created mortgage-backed securities. Sometimes, those securities had different “tranches,” each with different streams of income. For example, the first tranche’s income stream might be relatively secure, the second tranche’s income stream less so, and third tranche’s income stream even less so. Moreover, losses were allocated from the bottom up.
With this kind of structure, companies that repackaged mortgage-backed securities were able to obtain investment-grade ratings on billions of dollars of securities that had relative unsecured credit—that is, those subprime mortgages—as underlying collateral.
Now a whole new market for mortgage-backed securities opened—namely, to those with no expertise in evaluating the underlying collateral of mortgage-backed securities, who invested—based solely on the securities’ ratings.
That brought even more demand for subprime mortgages; it became a vicious circle as it grew from $35 billion in 1994 to $140 billion in 2000, an average annual growth rate of 26 percent, according to the Federal Reserve Bank. Similarly, subprime loans as a share of total mortgage originations grew from 5 percent in 1994 to 13.4 percent in 2000.
This process continued through 2005. Everything fell apart in 2006, as two economic situations combined to create what many industry insiders say was the perfect storm: interest rates began to rise, and housing prices began to weaken.
First, let’s look at interest rates. As noted above, a 2/28 ARM is originated with a low initial interest rate. After two years, the interest rates reset to a level based on the then-current six-month London Interbank Offered Rate (LIBOR) plus a margin. It resets at least annually thereafter. As an example of how this affected subprime borrowers, take the typical interest rate on a 2/28 ARM in early 2005, which was around 5 percent. At that time, ARMs taken out by subprime borrowers typically reset to LIBOR, plus about 6 percent. With LIBOR about 5 percent, loans charging 5 percent interest quickly jumped to 11 percent. A homeowner with a $200,000 mortgage would see monthly payments jump from around $1,200 to more than $2,000.
We all know what borrowers who cannot make their mortgage payment do: They refinance or sell their home. This time, though, they couldn’t refinance because interest rates were rising—and they couldn’t sell because the housing market was plummeting. In 2007, sales of existing single-family homes fell by 13 percent, the largest amount in 25 years, according to the National Association of Realtors. Moreover, the median home price dropped 1.8 percent to $217,000 for the entire year—the first annual price decline on record, which goes back to 1968. Lawrence Yuan, the chief economist at the National Association of Realtors, called this decline unlike any seen since the Great Depression.
Borrowers who could not make their mortgage payments had only one choice, so delinquencies and foreclosures on subprime loans started to rise. In the first quarter of 2006, the seasonally adjusted delinquency rate for subprime loans was 11.50 percent, according to the Mortgage Bankers Association. In the first quarter of 2008, it had risen to 18.79 percent. At that time, subprime ARMs represented 6 percent of U.S. loans outstanding and comprised 39 percent of foreclosures started.
Where are we now?
When the subprime meltdown first began, many economists thought it would be contained to 2007. But the crisis continues to unfold.
First, it does not appear that lenders—despite their claims to the contrary—rediscovered credit quality after the subprime woes first surfaced. Subprime loans that originated in 2007 are defaulting at even faster rates than those originated in 2005 and 2006, according to Moody’s. Seven percent of 2007 subprime loans defaulted within the first three months of origination, compared to just 4 percent of 2006 subprime loans.
Moreover, we are at the time of year when many ARMs reset. The value of subprime loans resetting to higher interest rates has been estimated be $500 billion in 2008, up from $400 billion in 2007. If that is indeed true, we are likely to see continued high default and foreclosure rates through 2008 and into 2009.
To support that projection, foreclosure filings grew by 53 percent year-over-year in June, according to RealtyTrac, which monitors default notices, auction sale notices, and bank repossessions. Nationwide, 252,363 homes received at least one foreclosure-related notice in June—one in every 501 U.S. households. Lenders repossessed more than 71,000 properties. The problem was nationwide, as foreclosure filings increased year-over-year in all but 11 states. Nevada, California, Arizona, Florida, and Michigan continued to have the highest foreclosure rates. In fact in Nevada, where Navellier & Associates is headquartered, one in every 122 households received a foreclosure-related notice in June, more than four times the national rate.
What does it mean for our old friends Fannie and Freddie?
As the credit markets have dried up, Fannie Mae and Freddie Mac have played an essential role in the country’s mortgage market. They have been the lenders of last resort, providing much-needed liquidity to the housing markets. As a result, banks and other lenders were able to make loans they otherwise wouldn’t have been able to make, and make them at lower rates.
Now that homeowners are defaulting and going through foreclosure at alarming rates, Fannie Mae and Freddie Mac are being forced to make good on their guarantees. Since last July, they’ve reportedly posted combined losses of close to $13 billion. And investors are worried there are more losses ahead.
Worries about the companies’ subprime exposure have led their stocks to decline for months, but the panic hit a crescendo in mid-July when a report from a Lehman Brothers analyst warned that a proposed accounting rule change would require the two companies to keep significantly more capital on hand. The Financial Accounting Standards Board is reviewing a rule that might force financial firms to move mortgage-backed securities currently off their balance sheets to their balance sheets. If Fannie Mae and Freddie Mac have to do this, Fannie Mae would have to add $46 billion to its reserves, the report said, and Freddie Mac would have to add $29 billion. In today’s tight credit market, that kind of cash would be hard to raise. Indeed, the chief economist for Moody’s Economy.com, Mark Zandi, has said that the companies may need to issue more stock to raise money, thus diluting the value of existing shares.
In fact, Freddie Mac is considering raising as much as $10 billion by issuing more stock to the public. Read More.
Adding insult to injury, not long after the Lehman Brothers report came out, a former Federal Reserve governor said he believes Fannie Mae and Freddie Mac are already insolvent and urged the federal government to take them over. Granted, that governor has long been critical of Fannie Mae and Freddie Mac, but it was a serious statement; if the government takes over the companies, shareholders would likely get nothing—and U.S. taxpayers would be on the hook for all the companies’ debt.
The selloff began then. Immediately after the markets opened on July 11, shares of Fannie Mae and Freddie Mac fell more than 47 percent from their already battered closing prices the day before. Although they made up much of their losses, Fannie Mae finished the day down 22 percent and Freddie Mac was down 3 percent. Both companies’ stocks were down around 45 percent for the week—and 75 percent for the year.
As evidence of their importance to the U.S. economy as a whole, the problems at Fannie Mae and Freddie Mac also weighed on the broader markets, at one point forcing the Dow Jones Industrial Average down below the 11,000 mark for the first time in nearly two years.
Is a government bailout likely?
The question is, are the companies really in trouble or is the selloff just the result of a temporary panic?
The Office of Federal Housing Enterprise Oversight (OFHEO) has reported that the two companies were “adequately capitalized,” meaning they have enough cash on hand to stay in business. And some people agree that the companies are doing just fine. For example, in a July research note, a Keefe, Bruyette & Woods analyst wrote that the OFHEO, the primary federal regulator for Fannie Mae and Freddie Mac, already requires reserves for off-balance sheet securitizations and due to those requirements, in part, the pair would not be affected by the new accounting standards. Even Senator Christopher Dodd, the chairman of the Senate Banking Committee, has defended the strength of the two companies.
Perhaps the bigger question on investors’ minds is, “If the companies are indeed in trouble, will the federal government step in and save them?”
Public Debt Concerns (WSJ)
GOP Slow to Accept (NPR)
As noted above, the law that created Fannie Mae and Freddie Mac explicitly says the government does not guarantee the loans. However, there is a widespread belief that Fannie Mae and Freddie Mac are backed by some sort of implied federal guarantee. Vernon L. Smith, 2002 Nobel Laureate in economics, has even created a new name for such an arrangement, calling Fannie Mae and Freddie Mac “implicitly taxpayer-backed agencies.” As a result, a majority of investors believe that Fannie Mae and Freddie Mac are simply too important to the economy for the federal government to let them fail, and policymakers would step in to prevent a default.
That seems to be the case. Although a full-scale bailout has not been discussed, on July 13, the U.S. Department of the Treasury and the Federal Reserve announced a plan (Watch Bloomberg Video)
to support Fannie Mae and Freddie Mac should it become necessary. Treasury Secretary Henry Paulson said the Bush administration will ask Congress to enact legislation to increase temporarily the companies’ lines of credit with the Treasury and also allow the Treasury to buy stock in the companies. In addition, the Federal Reserve said it will give Fannie Mae and Freddie Mac the same access to Federal Reserve Bank of New York funds as commercial banks and Wall Street firms.
“They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future,” Paulson told legislators, in an effort to calm investor anxiety.
However, for every position, there is an opposing position. Many people say the federal government should allow Fannie Mae and Freddie Mac to falter. After all, their poor mortgage lending practices helped put us in the subprime crisis—and many think that there is no crisis that cannot be made worse by government intervention. By stepping in to save Fannie Mae and Freddie Mac, it can be argued, the government will put us in an even bigger financial muddle.
Jim Rogers Video
See Full Fannie/Freddie WSJ Coverage
Where do we go from here?
Investors started the week panicked about the financial sector after a government takeover of IndyMac (Listen NPR) late last Friday, and widespread uncertainty about Fannie and Freddie’s future.
But as the week progressed, investors got some relief from a big decline in oil prices (down about 11% for the week), and a stronger-than-expected earnings announcement and 10% dividend increase from Wells Fargo. The San Francisco-based bank’s results, which were down year/year (but not as much as feared), triggered a big relief rally in the financial sector. JPMorgan and Citigroup’s better-than-expected quarterly results kept the momentum going, despite a much weaker than expected announcement from Merrill Lynch.
Merrill Lynch’s $9.75 billion writedown ($3.75 billion more than expected) and $4.97 billion quarterly loss probably would have had a much bigger impact on the market today had it not been for a rule enforced by the SEC earlier in the week that prevents shorting in Fannie Mae, Freddie Mac, and 17 other financial institutions (one of them being Merrill).
SEC Shorting Rule
The rule caused a lot of short positions to cover in the financial sector during the week, and therefore provided additional buying pressure underneath the already-rallying group. As a result, the sector had an enormous bounce off oversold levels.
Does this mean it’s safe to go back into financials? No. In our opinion, there will likely be several bank failures ahead since the government cannot save everyone, and many banks sold disproportionate amounts of subprime mortgages.
This is also not the time to go bottom fishing in other beaten down sectors. Let’s not forget that we have a stagflation environment on our hands (stagnant economic growth and high inflation). As such, we recommend that investors stay focused on the narrow part of the market that still has impressive profitability characteristics. Many of these stocks underperformed this week, as investors flocked to the financials, but we expect them to rebound as a group during earnings season.
These types of stocks offer strong return potential over the long run if you continually rotate into the companies that have the highest profitability potential. That’s exactly what we do in our growth portfolios at Navellier. We consistently invest our clients’ assets in stocks that have the strongest profitability characteristics.
Stay the course.