Mortgage Banking
October 2008
In a startling weekend turn of events, the federal government took the two giant government-sponsored enterprises into conservatorship. The bold move seems to be a sign of the times.
By Robert Stowe England
In a historic move, the newly created Federal Housing Finance Agency (FHFA), after what it called "a painstaking review," took control of mortgage giants Fannie Mae and Freddie Mac on Sunday, Sept. 7, by placing them into conservatorship. The boards of both Fannie and Freddie consented to the move, according to James B. Lockhart, director of FHFA, the successor organization to the Office of Federal Housing Enterprise Oversight (OFHFO).
At the same time, the federal government purchased 79.9 percent ownership of each of the government-sponsored enterprises (GSEs) with the purchase of senior preferred stock for $1 billion for each company. Thus, both Fannie and Freddie became overwhelmingly owned by the federal government.
This purchase of preferred equity in the two enterprises also dramatically reduced the value of the once high-flying common shares to 25 cents for Fannie and 39 cents for Freddie.
The government takeover ended three months of mounting market nervousness over the ability of the two GSEs to fulfill their mission in providing housing finance in the face of mounting losses in their retained portfolios of mortgages and mortgage bonds.
The chief executive officers at the two firms – Daniel H. Mudd at Fannie and Richard Syron at Freddie – were replaced with two new executives. Herbert M. Allison, formerly chairman, president and chief executive officer with TIAA-CREF, is Fannie Mac's new president and chief executive officer. David M. Moffett, formerly vice chairman and chief financial officer with U.S. Bancorp, is Freddie Mac's chief executive officer. Both Mudd and Syron agreed to a government request to stay on to help with the transition, while current senior management teams remained in place at both enterprises.
At the same time, the Department of the Treasury took several additional measures to provide financial backstops to significantly shore up the financial condition of the GSEs to ensure they could continue playing their vital role in the housing market.
In addition to its initial $1 billion capital injection, Treasury announced a program to provide, as needed, capital invested as preferred stock to ensure that the companies maintain positive net worth. Treasury has agreed to provide, if it should prove necessary, up to $100 billion of capital for each GSE to ensure that liabilities do not exceed assets in each company.
Treasury also announced agreements with each GSE to purchase mortgage-backed securities (MBS) from new Fannie and Freddie MBS issues in the open market. Treasury further agreed to provide a secured credit lending facility to provide liquidity to each entity, if needed, until the end of 2009.
The rationale for the move
Why was the move necessary? Lockhart explained the reasoning at a news conference as follows: "During the turmoil last year, [Fannie Mae and Freddie Mac] played a very important role in providing liquidity to the conforming mortgage market. That has required a very careful and delicate balance of [the] mission [of providing lower-cost housing finance] and [the] safety and soundness [of each GSE]. A key component of this balance has been their ability to raise and maintain capital," Lockhart said.
Indeed, the two GSEs' share of all new mortgages had reached 84 percent of all originations by the second quarter of 2008, according to Inside Mortgage Finance (see Figure 1), helping make up for the absence of the private-label MBS market and a sharp retrenchment in mortgage lending by portfolio lenders. (By comparison, the GSE share of mortgage originations stood at 45.6 percent in the second quarter of 2007 and 37.4 percent for all of 2006, according to Inside Mortgage Finance.
As GSE worries and mortgage interest rates rose in the three months prior to the Sept. 7 announcement, however, Fannie and Freddie's combined share of originations began to fall, Lockhart said. The GSEs' share for the third quarter is likely to come in "at or slightly under 75 percent," according to Guy Cecala, president of Inside Mortgage Finance. The Federal Housing Administration (FHA) has taken the market share lost by the GSEs, Cecala says.
Over the three months prior to the Sept. 7 announcement, market conditions began to undermine the ability of Fannie and Freddie to meet the demand for housing finance, according to Lockhart. "Unfortunately," he explained, "as house prices, earnings and capital have continued to deteriorate, [the GSEs'] ability to fulfill their mission has deteriorated. In particular, the capacity of their capital to absorb further losses while supporting new business activity is in doubt," he said on Sept. 7.
Treasury Secretary Henry Paulson said the mounting troubles for the enterprises derived from "the inherent conflict and flawed business model embedded in the GSE structures, and . . . the ongoing housing correction." And, Paulson continued, the federal government could not let Fannie and Freddie continue to limp along.
"I have long said that the housing correction poses the biggest risk to our economy," the Treasury secretary noted. "It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing. Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance."
The impact on spreads and share prices
The deteriorating outlook for Fannie Mae and Freddie Mac was reflected in their falling share prices. Fannie's shares fell from $25.71 on June 6 to $7.07 on July 15, reaching a level that made it highly unlikely the firm could raise additional capital. Similarly, Freddie's shares fell from $25.20 on June 5 to $5.26 on July 15. By Aug. 20, Fannie's shares stood at $4.40 while Freddie's fell to $3.16 on Aug. 21. On Sept. 8, after the government takeover, Fannie's shares fell to $0.73 and Freddie's fell to $0.88. It was virtually a complete wipeout for equity holders.
Even as stockholders were losing their shirts, the benefits of the government takeover and financial backstop became quickly apparent. Spreads between yields on Fannie Mac's current-coupon 3o-year fixed securities and 10-year Treasuries immediately fell 34 basis points to 159 basis points. The spread had reached a 22-year high of 238 basis points on March 6 before falling back, and then rose again to its secondhighest level of 216 basis points on Aug. 18.
In the first week following the government takeover, the average rate on a confirming fixed-rate mortgage (FRM) had fallen to 5.82 percent from an average of 6.08 percent the previous week. This sent mortgage applications soaring 33 percent, according to the Mortgage Bankers Association's (MBA's) weekly report on mortgage application activity for the week of Sept. 12, released on Sept. 18. Nearly two months earlier, on July 23, the average rate had reached a six-year high of 6.51 percent, adding further headwinds to an already struggling housing market.
New law grants expanded authority
The authority to place the two giant GSEs in conservatorship was granted to the Federal Housing Finance Agency on July 30 when President Bush signed into law the Housing and Economic Recovery Act of 2008 (HERA). The new law reforms the regulatory oversight of the GSEs as well as the Federal Home Loan Banks. GSE reform had stalled in Congress for years, but moved quickly forward as Fannie's and Freddie's woes began to mount over the summer.
The agreements announced by FHFA and Treasury on Sept. 7 do not indicate what the ultimate resolution of Fannie and Freddie will be-whether they will be restored to something close to their present form, broken up and sold in the private sector, or some other possible outcome is something that will be determined in the future.
The conservator's responsibility is to oversee the two GSEs and return them to a sound and solvent condition. The powers of the directors, officers and shareholders are transferred to the designated conservator-in this case FHFA, although another party could have been named conservator. In addition, the conservator's goals are "to help restore confidence in [each GSE], enhance its capacity to fulfill its mission, and mitigate the systemic risk that has contributed directly to the instability in the current market," states a fact sheet from FHFA.
A few other changes
The takeover announcement also included notice of a number of changes in the way that Fannie and Freddie will do business. For starters, there is to be no lobbying by either GSE, and the charitable activities of both companies are under review.
To preserve $2 billion a year in capital, all dividends from common and preferred stock have been cancelled. Shares will continue to be traded, although they remain penny stocks. Fannie and Freddie will continue to be able to buy and sell investments and complete financial transactions. Subordinated debt interest and principal payments will continue to be paid.
During the conservatorship, "FHFA will continue to work expeditiously on the many regulations needed to implement the new law," Lockhart said at the press briefing. "Some of the key regulations will be minimum capital standards, prudential safety-and-soundness standards and portfolio limits." The new law gives FHFA more powers to regulate the GSEs and set new standards for their operation.
Treasury's role
Paulson, at the Sept. 7 press briefing, provided details of Treasury's pivotal role in the rescue and restructuring of Fannie and Freddie. As part of its agreement to inject capital, Treasury capped the size of each company's retained mortgage and MBS portfolio at $850 billion as of the end of 2009. The size of each GSE portfolio is set to decline by 10 percent a year until each reaches $250 billion, according to the Treasury plan.
Under the first of three agreements-the senior preferred stock purchase agreements-Treasury will purchase senior preferred stock in sufficient quantity to ensure that each enterprise has a positive net worth. This commitment "is more efficient than a one-time equity injection," Paulson said, "because it will be used only as needed and on terms that Treasury has set."
The first capital injection of $1 billion purchased the senior preferred stock with warrants giving the government its 79.9 percent share. The warrants, Paulson explained, are there to protect the taxpayer. The preferred stock will pay a 10 percent coupon, quarterly dividend payments and a quarterly fee starting in 2010.
Paulson said the decision to acquire a 79.9 percent ownership stake is necessary to address the "ambiguities" in the charters for the two enterprises. The charters have been perceived by the markets as insinuating an implicit government support for the agency debt of the two enterprises, as well as a guarantee for the mortgage-backed securities issued by the enterprises.
"Our nation has tolerated these ambiguities too long and, as a result, GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free," Paulson said.
"Because the U.S. government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS," he said-estimated at more than $5 trillion, which is more than the total amount of outstanding U.S. debt, according to Treasury.
The senior preferred stock program has a capacity of $100 billion for each GSE, and is indefinite in duration. The $200 billion for both GSEs is "an amount chosen to demonstrate a strong commitment to the GSEs' creditors and mortgagebacked security holders," according to a Treasury fact sheet. "This number is unrelated to the Treasury's analysis of the current financial conditions of the GSEs," the fact sheet states.
If the FHFA determines that a GSE's liabilities have exceeded its assets under generally accepted accounting principles (GAAP), Treasury has agreed to contribute cash capital to the GSE in an amount that would equal the difference between liabilities and assets, according to Treasury. Each time such a capital contribution is made, it will be added to the senior preferred stock held by Treasury.
There were several covenants that applied to the enterprises as part of the senior preferred stock agreements. Without prior consent by Treasury, the enterprises cannot make any payment to purchase or redeem their capital stock, or pay dividends, as noted earlier, including preferred dividends-other than the dividends on the senior preferred stock owned by the federal government. Further, neither Fannie nor Freddie can issue capital stock of any kind without Treasury's consent.
The enterprises also may not sell, convey or transfer any of their assets outside the ordinary course of business, except as necessary to meet their obligation under the agreements to reduce their portfolio of retained mortgages and MBS. Further, neither Fannie nor Freddie can increase its debt to more than no percent of its debt as of June 30, 2008. In addition, neither enterprise can acquire or consolidate with, or merge into, another entity.
Neither can Fannie or Freddie terminate their conservatorship other than in connection with receivership. Finally, the GSEs also may not enter into any new or adjust any existing compensation agreements with named executive officers without consulting with Treasury.
The second step taken by Treasury is to provide a new secured lending facility-not only for Fannie Mae and Freddie Mac, but also for the Federal Home Loan Banks. Paulson said that the willingness of the federal government to ensure that the GSEs will preserve positive net worth should put them in a stronger position to fund their business activities in the capital markets. Congress granted Treasury temporary authority to lend money to the GSEs and the Federal Home Loan Banks until the end of 2009. Lockhart has said he does not expect the Federal Home Loan Banks to have any need for the lending facility.
The third step taken by Treasury is a temporary program to purchase newly issued MBS from Fannie and Freddie "to further support the availability of mortgage financing for millions of Americans," according to Paulson. This effort was taken partly because the alternative-having Fannie and Freddie dramatically increase their MBS portfolios-was not considered viable.
"Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and [Fannie and Freddie] MBS indicate there is no reason to expect taxpayer losses from this program," Paulson said. "In fact, it could produce gains."
Initially, it was unclear how significant the Treasury purchases of new GSE MBS would be. On Sept. 19, however, Treasury announced an expansion of this program with a $10 billion purchase by week's end. At the same time, Paulson indicated that Fannie and Freddie would step up their purchases, too. However, according to Treasury, the $850 billion limit on portfolio holdings would remain in place for each GSE.
More work to do
Paulson summed up the importance of the actions taken by FHFA and Treasury as follows: "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth, from family budgets to home values, to savings for college and retirement."
In discussing the future of the GSEs, Paulson recognized there is an inherent conflict between an attempt to serve both shareholders and a public mission. The ultimate decision on how to resolve that conflict rests with the new Congress and the next administration, he noted.
"There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policy-makers must address the issue of systemic risk. I recognize there are strong differences of opinion over the role of government in supporting housing, but under any course policy-makers choose, there are ways to structure these entities in order to address market stability in the transition and limit systemic risk and conflict of purposes for the long term. We will make a grave error if we don't use this time-out to permanently address the structure issues presented by the GSEs," Paulson said, noting that he would put forth his own views on long-term reform of the enterprises and looked forward to a "timely and necessary debate."
Although in a worst-case situation both Fannie and Freddie could ultimately be liquidated, that decision would have to be made by FHFA. Should either Fannie or Freddie ultimately be liquidated, it would require that the charter for each company be transferred to a new entity, since the charter can only be dissolved by an act of Congress. The FHFA is overseen by a Federal Housing Finance Oversight Board, made up of four people: the Secretary of the Treasury, the secretary of the Department of Housing and Urban Development (HUD), the chairman of the Securities and Exchange Commission (SEC) and the director of FHFA, who also chairs the board.
Copyright 2008 Mortgage Bankers Association of America. Reprinted With Permission
