Delisted but Not Gone: What to Do About Fannie and Freddie?

Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac

Even though U.S. taxpayers now own most of Fannie Mae (FNM) and Freddie Mac (FRE), the fact that shares of the mortgage giants still traded on the New York Stock Exchange always provided a faint hope that one day they would pay back the billions of dollars they lost making bad bets on home loans.

But shares of Fannie Mae, which hit $89 less than a decade ago, fell below the required minimum of $1 a share this week, so both firms ended their listings on the exchange Wednesday. What's not ending is the huge mountain of unpaid bills that could saddle taxpayers with up to $1 trillion in bad debt.

Fannie and Freddie together guarantee about $5 trillion in single-family home mortgages, about half the total outstanding, according to the Federal Reserve. Since the government seized the companies in September 2008, and placed them under a form of bankruptcy called conservatorship, taxpayers have been on the hook for any shortfall in capital. When mortgage borrowers don't pay -- $340 billion in loans were past due in March – Fannie and Freddie must absorb the losses.

Another Leak That Can't Be Capped

The government has already spent $140 billion providing capital to the two companies. How much more they'll eventually require is anyone's guess. Combined they lost $94 billion in 2009 and $18 billion in the first quarter, leading to the collapse in their share prices. Leaving the NYSE won't hurt the companies -- it's just another confirmation of how dire their financial situation has become.

Sean Egan, principal at Egan-Jones Ratings, a Philadelphia-based ratings firm, says he thinks losses on the firms' loan portfolios could top $1 trillion. "Our view is that a reasonable worst case is about 20% of the $5 trillion exposure," he says. He points to the fact that Merrill Lynch sold a portfolio of poorly performing mortgage debt to a Texas firm called Lone Star in July 2008, for $6.7 billion, at a loss of 78%.

"This is similar to the BP oil spill -- they can't cap the leak," says Anthony B. Sanders, a professor of real estate finance at George Mason University in Fairfax, Va. "This makes the oil spill look like small potatoes."

Fighting Only Half the Fight

The problem is that no alternative plans exist to halt or even slow the losses from Fannie Mae and Freddie Mac. While the Obama administration has proposed a sweeping overhaul of the financial services industry, which is being considered by a congressional conference committee this week, the proposal doesn't include Fannie or Freddie. The administration, which had promised a rescue plan in February, now says a proposal won't be ready until next year.

"Overhauling the banking system without fixing Fannie and Freddie is like fighting terrorists without attacking the jihadi ideology motivating them," Investors Business Daily said in an editorial Monday.

Last week, the House blocked a Republican proposal to end the conservatorship of Fannie and Freddie within two years. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, argued that because the two firms weren't taking losses on new loans, the measure wouldn't save taxpayers any money.

A Cure for Faulty Securizations?

Peter J. Wallison, a fellow at the American Enterprise Institute, says the government should be looking at all possible alternatives to Fannie and Freddie that don't involve the taxpayer taking on the risk. "It is very unclear to me that the government is looking at anything right now," he says. "And if another system is created, it will take many years to put into place. So, meanwhile the taxpayers will be taking all the risks."

Both Wallison and Sanders believe the government should privatize Fannie and Freddie or simply wind down the two companies over a period of about three years, or at least reduce their presence in the mortgage market, where accounted for 75% of the market last year.

An alternative has to be found for the securitization market, in which banks and other mortgage lenders bundle loans into bonds and sell them to investors. During the housing boom, they often did so without checking the credit quality of the underlying loans. The value of these bonds plunged when the housing bubble burst, damaging banks around the world. The securitization market has been mainly frozen for two years, with few signs of thawing. The problem is securitizations provided much of the capital that funds mortgages, and in their absence far less lending is possible.

One potential solution is a financial instrument called a covered bond, which has been used in Europe since the 18th century to finance residential mortgage lending. Unlike securitizations in the U.S., covered bonds remain on the originating bank's balance sheet. That means the banks are much more likely to ensure that strict credit standards are applied, and investors know the banks are still responsible for the debts in case anything goes wrong.

Covered bonds have been used successfully in Germany and Denmark, which have local government lenders but no state equivalents of Fannie and Freddie. A bill is now in Congress to make the regulatory changes necessary to allow U.S. banks to sell covered bonds.

"Better Off Renting"

Sanders says that even if Fannie and Freddie are allowed to survive, lots of problems with defaults would be solved by raising the minimum down payment to 20% or more. He says both firms used to have such limits before the housing boom and that bigger down payments would keep borrowers from becoming overextended.

Wallison and Sanders also agree that the federal government had gone too far in encouraging people to become homeowners, especially low-income families that were unfamiliar with such exotic instruments as adjustable rate mortgages. "Unless we change our national housing policy and admit that some people are better off renting and saving their money, we're going to repeat the same problem," Sanders says.

Wallison says he's concerned that Congress will avoid dealing with the issue by simply reconstituting Fannie and Freddie and giving them new oversight. He says bank regulators had failed miserably and can't be counted on to save the mortgage giants. Fannie and Freddie may be delisting their shares, but they're not going away anytime soon.