Fannie Mae & the Banking Industry: A Tragic Comedy

Hamlet: Do you see yonder cloud that’s almost in shape of a camel?

Polonius: By the mass, and ’tis like a camel indeed.

Hamlet: Methinks it is like a weasel.

Polonius: It is backed like a weasel.

Hamlet: Or like a whale.

Polonius: Very like a whale.

Vilified as Frankenstein-like twin mutants choking off the blessings and efficiencies of free enterprise, or acclaimed as champions of The American Dream and providers of mortgage credit to millions of working class families, Fannie Mae and Freddie Mac reflect the contradictions inherent in their federal charters. Created by the federal government in order to increase the supply of mortgage credit and provide liquidity in the secondary mortgage markets, Fannie and Freddie were licensed to be corporations with select and valuable government-like privileges. So much so has their powerful position enabled them to capture market share that they currently guarantee three trillion dollars-worth of mortgage related securities. This unique, if nebulous, status has become particularly pertinent as both Fannie and Freddie have been beset by various financial tribulations and very significant accounting issues, which would have severely damaged an ordinary corporation. However, their privileged standing as government-sponsored enterprises (GSEs) has led many to conclude that Fannie and Freddie are, if not children, at least nephews of Uncle Sam. In the words of Federal Reserve Board Chairman Alan Greenspan: “…most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt.” And although there have been numerous proposals advanced to devise an enhanced regulatory framework capable of containing the risk posed by what have become extremely large and highly leveraged financial institutions, no legislation has yet been approved by Congress.

Hamlet: Madam, how like you this play?

Queen: The lady protests too much, methinks.

Despite the market’s preferential treatment of Fannie and Freddie insured debt, senior regulatory officials, as well as executives at Freddie Mac and Fannie Mae, are technically correct in their repeated assertions that securities issued by Freddie and Fannie are not obligations of and not insured by the US government. Perhaps it is only prudent for the federal government to consistently remind the market that Fannie and Freddie are on their own, considering how much money is at stake. Still, it is somewhat odd that something so clear needs so much repeating. Is there perhaps still some lingering doubt?

In addressing the challenge that Fannie Mae and Freddie Mac face in hedging their massive mortgage portfolio pre-payment risk, Greenspan crystallized one of the issues at the very core of the current controversy: “In essence, the current system depends on the risk managers at Fannie and Freddie to do everything just right, rather than depending on a market-based system…” Let us consider what might happen if Fannie’s and Freddie’s risk managers “get it wrong” and these companies would face extremely severe financial difficulty. Why can’t we take the federal government at its word that it will permit these financial giants to crash? Their creditors were warned many a time. Let them take their losses and be more careful in the future.

Marcellus: Something is rotten in the state of Denmark.

This past April the FDIC reported that FDIC insured commercial and savings banks hold almost $300bn-worth of direct (non-collateralized) Fannie and Freddie debt. In addition, they own $770bn-worth of mortgage pool debt insured by Fannie and Freddie. The bank industry holdings of Fannie and Freddie backed securities thus amount to 155 per cent of their total tier 1 capital. This incredible state of affairs is possible because banks are allowed to classify the Fannie and Freddie bonds in their investment portfolios in the same risk-free category as US treasury obligations. If we believe senior administration officials when they emphatically and repeatedly negate even the possibility of a government bailout of Fannie and Freddie, then the banking industry’s trillion-dollar investment in Freddie and Fannie insured bonds is a truly astounding and risky contradiction. Perhaps this paradox will help explain why the bond market continues to give preferential status to Fannie Mae and Freddie Mac debt. After all, if the highly regulated and financially sophisticated banking industry has voluntarily invested so heavily in Fannie and Freddie bonds, there must be a good reason.

What is sometimes forgotten in the current debate regarding Fannie’s and Freddie’s financial condition is that commercial and savings banks in the US are extremely vulnerable to knock-on contagion from these mortgage titans. An FDIC report released this past March estimates that the US banking industry could weather a mere 0.6 per cent (60 basis points) drop in the value of Fannie’s and Freddie’s direct obligations and a 0.4 per cent drop on mortgage pool debt by sustaining a sum total $17bn market loss. Not very pleasant, but not devastating. What about a 3 per cent drop in market value? How about 6 per cent or 9 per cent? Is that so unimaginable? It happens to other corporate bonds. Some of them even default.

What would be the most probable outcome of a significant drop, or perhaps even just the distinct threat of a major decline, in the value of Fannie and Freddie debt? The federal government would likely conclude that it would be less costly to employ early damage control in supporting Fannie and Freddie directly, than to deal with the aftermath of a quickly spiraling, system wide, banking industry meltdown. Perhaps this is one reason that banks, as well as other investors, purchase Fannie and Freddie debt at prices and (more significantly) in concentrations that would be unheard of, if Fannie and Freddie were like any other private corporation.

As long as banks are permitted to continue the farcical charade of carrying a trillion dollars of Fannie and Freddie bonds, which are supposedly not backed by the federal government, in the same unlimited quantities as their investments in US treasury securities, then the bond market’s perception that the US government will back Fannie and Freddie is closer to the truth than the multitude of denials by federal officials and Fannie Mae executives. Effective regulatory reform necessitates the carefully and gradually introduced requirement that the banking industry treat Fannie and Freddie debt like any other similarly rated corporate security.

The author thanks the commercial banker who comments on the classification of GSE debt in the same capital risk category as explicitly backed government debt: “As an Office of Thrift Supervision regulated entity, we are to report GSE debt in the 20% risk-weight category.  I am not certain but I believe this is consistent across the OCC, FRB & State regulatory agencies.AAA corporate debt, in fact all corps, are 100% risk-weighted. You could contrast this 100% ratio to the 20% required for what are essentially private companies (Fannie Mae & Freddie Mac).  The essence of your article is not affected.”