How does the Fannie Mae and Freddie Mac bailout affect you?

by Xin Lu on 8 September 2008 23 comments
Photo: Fannie Mae

Yesterday Henry Paulson decided to use the power given to him by the housing bailout bill to officially take over Fannie Mae and Freddie Mac. This is a decision that has a huge impact on global financial markets. So how does this change affect you? Here is a list of the winners and losers in this situation.

Winners

Homebuyers with cash - The news of the takeover sent mortgage rates on 30 year fixed conforming loans by almost a quarter of a percent according to Bankrate and it is expected to fall a bit more in the next few weeks. So homebuyers who are looking to get a new loan may be saving quite a bit of dough. Lending criteria is more stringent than previous years so loans may only be available to the most qualified borrowers with a substantial downpayment and great credit.

Investors in financials and homebuilders - The stock market rallied on the news that the government is taking over Fannie and Freddie. The biggest winners are the financial and homebuilding industry.

Banks that invested in Fannie and Freddie's debt - Fannie and Freddie sold trillions of dollars in mortgaged backed securities to central banks all around the world. For example, China's People's Bank owns more than $300 billion in Fannie and Freddie's mortgage backed securities. If both of these companies defaulted on all of these securites the Chinese national bank may have gone bankrupt.

Non-Americans
- As I said in the previous point, many foreign banks purchased the debt backed securities issued by Fannie and Freddie. This bailout by the United States government essentially protected the assets of many foreign banks and non-Americans in these countries should be thankful that their banks are not going bankrupt. Additionally, the money used for the bailout is straight from the pockets of American taxpayers.

Losers

American taxpayers - This bailout is not free. Noone knows the final damage this bailout will do to the Treasury, but most believe that the losses will be in the hundreds of billions. Considering that Fannie and Freddie holds approximately $5 trillion in home loans and currently more than 9% of loans are in the process of defaulting, then simple math tells us that these two companies could potentially lose $450 billion. Additionally, taxpayers will have to pay for the upkeep and operations of these companies so the costs will keep on increasing for years to come.

ARTICLE CONTINUES BELOW

Banks depending on Fannie and Freddie dividends - Dividends from Fannie and Freddie's stocks have been eliminated. According to this article, many small banks around the country used the preferred shares of Fannie and Freddie as income investments. Now that the dividends are eliminated these banks no longer have a steady income stream and may fail.

Existing shareholders of Fannie and Freddie's stocks - This is pretty obvious since the stock price of Fannie and Freddie fell to under $1. Technically these two companies are now under a conservatorship which basically means that they are bankrupt. As a result those who hold these stocks directly or through a mutual fund are seeing losses in their investments.

Home sellers facing plunging home prices - Even though this bailout will reduce mortgage rates for the best borrowers, it probably will not do anything to stem the plunging home prices in the most bubblicious areas of the country. Home sellers that are upside down in their loans will still have to deal with losses by themselves.

Lobbyists for Fannie and Freddie - They have been silenced now that the government owns Fannie and Freddie.

The bottom line is that noone really knows what exactly will happen in the next couple years, but letting Fannie and Freddie fail completely does not seem like a valid option. The global reach of Fannie and Freddie is humongous and this takeover move has some commentators saying that America is now "more communist than China" and "more socialist than France ". Indeed, America is using public funds to take over more than 50% of the credit market. Whether this decision makes America stronger or weaker in the global economy is up for debate. As consumers, all we can do is be vigilant as to where our money is kept and be careful when we enter into important financial contracts. Finally, I hope that a positive effect that comes out of this giant mess is that Americans will learn to save again and realize that an economy held up by debt cannot be sustained.

 

 

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Guest's picture

My husband just got a small loan funded by fannie mae to help pay for his phd. Do you know what would happen with something like this?

Xin Lu's picture
Xin Lu

I wasn't aware that Fannie Mae dealt with student loans.  Maybe you are thinking of Sallie Mae?  That's a different institution. I think your loan probably wouldn't be affected.

Guest's picture

You are right, it is Sallie Mae. Thanks!
(Love your articles, by the way!)

Guest's picture

My opinion is that there is always more trouble when the government gets involved. Bureaucracy never streamlines a process, it has a way of impeding it. Personally, I see higher rates, and less sales. More importantly I see a lot less consumer confidence in the economy and stocks. The government intervention makes all shares of common almost worthless, and totally worthless if the two companies never emerge out of conservatorship. From what I have read online the largest holders of much of the common stocks are insurance companies and pension funds. What happens to the confidence of their investments? What happens if your retirement fund is invested in these 2 companies? If I lost money on a sure bet, I would be not likely to invest more with the same company. That is a hard sale! The reality is that the shift and the losses will be borne more by the US Taxpayers.

Guest's picture
Guest

When a home loan defaults the bank doesn't lose 100% of the value. They'll lose a little to a lot, but they don't turn around and give a foreclosed home away, they sell it, making back as much of their money as possible.

Xin Lu's picture
Xin Lu

True, when a home loan defaults the bank usually doesn't lose 100% of the value, but sometimes they lose even more by having the home on their books and trying to sell it.  In the case of $1 homes in Detroit, banks are losing more than 100% of the value.  In the first quarter Fannie was disposing homes at about 74% of their loan value according to this article: http://www.chicagotribune.com/business/chi-re-fannie-unsold-home-0803aug...

This amount is still falling so the losses will still be in the hundreds of billions.

Guest's picture

An additional beneficiary of this horrendous environment for the Financials is that some banks are offering CD rates well above the national average. They're mortgaging their long term profitability in order to meet near term liquidity obligations. I just did a post tonight on the topic.

As far as government involvement, it's generally a bad idea. Here, it was borne out of necessity. The alternative was much worse. There was suffering by shareholders (as their should be) and the taxpayers may end up shelling out nothing in the end if the liquidity/backing hedge provided is adequate. If not, well, the Fed can continue to print more money, devalue our dollar some more and introduce the next bailout plan.

Guest's picture
Dangerman

I'm not so sure that Homebuyers with cash are helped by this government bailout. You're right that the interest rates go down a little, but what about the actual price of the house? The buyout will stem the price drop by enabling more people to have "easy money" mortgages. That 0.5% in interest isn't going to outweigh the 10% lower price that the house would have sold for.

This deal is bad for everyone.

Xin Lu's picture
Xin Lu

Actually I don't think this bailout will stem the price drop very much.  Additionally, 0.5% in interest is a huge difference on a mortgage.  If you consider that homebuyers pay mostly interest in the beginning of their mortgage, a 0.5% drop on 6% is a 8.3% drop. 

Guest's picture
vesperto

I think it's strange that commentators keep saying that taxpayers are going to pick up the bill for this takeover. The truth is that no one dares to raise taxes in the current political climate. Any suggestion of a tax increase generates cries of "Tax and spend liberal!" from the Republicans, and then the Democrats fall all over themselves to assure voters that they plan to cut taxes, not raise them.

In the end, the federal government will pay off the loan guarantees it has assumed by issuing more debt. Then it will pay that debt (and the related interest) by issuing still more debt. When will people realize that even the U S government can't keep this pyramid scheme going forever?

The good news is that your average mortgage loan is now as secure as a U S Treaury bond.

The bad news is that a U S Treasury bond is now as secure as your average mortgage loan.

Guest's picture
vicki

At some point, won't the government "spin-off" Fred and Fran since it appears they can't close up shop?

Guest's picture
Kelja

For those who wish for more government involvement, for larger government with more regulatory power - this is what you end up with.

The storm is just starting - today, Tues., Lehman Bros. is wobbling, it will probably go out of business or be folded into another investment bank. Wamu, Washington Mutual is next. With the failure of Wamu, the FDIC will effectively be bankrupt. The FDIC will have to to the government for a handout. The big 3 automakers are lined up at the begging bowl asking for 50 billion.

Small and large banks having purchased fannie/freddie perferred stock for income, will no longer have that income.

I know Fannie/Freddie's bailout was necessary, but it's wrong nonetheless. We have effectively burdened our children and our grandchildren with our debt.

All I have to say, you haven't seen anything yet.

Guest's picture
Wesley

I want Greenspan back!!!

Guest's picture
Kevin

Winners - you forgot the Fannie Mae and Freddie Mac CEOs and other executives and their golden parachutes who bankrupted the company then left for their mansions and country clubs. Thanks, guys!

Guest's picture

Retirees benefit, as their incomes will rise, when the Fed is forced to begin raising rates. As the Fed raises rates, inflation will decline, an added bonus for retirees.

http://www.iplanretirement.com/retirementblog/fannie-freddie-you/

Working people are the big losers.

Guest's picture
Zeke

I didn't see anything in the article about Fannie and Freddie *bonds*. Are the owners of these going to be winners, losers, or neutral?

Guest's picture
Christian

Dear God no more Greenspan, does everybody forget that he created two massive asset bubbles, fist the dot-com bubble now the mortgage bubble. He was warned years in advance of the pending storm but chose to ignore the whole thing and because of this and all the foreign debt we have,(by the way the entire Beijing Olympics was payed for by the interest payments that China gets form all the US T-bills it has) we have to bail out these companies or foreign countries will no longer invest in our financial companies and that will bring our credit markets to stop.

lghbob's picture
lghbob

 

Here's a copy of an email I had sent to my friends on the same subject, from a little different perspective...   

I read Xin Lu's article with a sense of deja vu

 

...........................................................................................................

The Freddie /Fannie problems is not well understood, by the public, by congress, or by the experts..

The total amount of Mortgages outstanding in the US is about 12 trillion dollars, of which Freddie and Fannie have guaranteed about 5 Trillion.  

Mortgages are debts, that come due over a period of time, thus, when you buy a home, for let's say $200,000, over the thirty year period, the total amount that will be paid, including interest at 7.5%, would be $504000. 

 

The $504,000. Is debt.  Fannie Mae buys this debt from banks that issued the mortgage.  In effect, the bank transfers the mortgage that is owed, to Fannie Mae... but realizing that there is risk involved (that the mortgage will not be paid off in full), they will sell the debt for an amount less than the total amount due. 

 

For instance, a mortgaging bank may sell the $504000 owing, for $480,000... to Fannie Mae..  Fannie Mae now, can take the full amount of the debt, and hold it on its books,  or in turn sell it off to others.  (The mortgaging bank, is then free to reinvest the amount it received for the mortgage). 

 

Some people think that the stockholders own this debt.   That is not so.   They own shares in the company.  The Debt is separate.

 

The "others" that Fannie sells the debt to, include, but are not limited to: .1.  Sovereign Wealth Funds owned by Foreign Nations . (China alone, owns approximately $300 Billion of this debt) .  2. Pension Funds... Private and Public.  2. Banks and Brokers. 3. Endowment Funds,  4. Insurance Company funds, 5. Private individuals.  This debt is usually sold at "auction".

 

So far, so good.  Initially, the  operation of Fannie Mae was governed by strict rules, requiring the Corporation to adhere to accounting standards, to maintain operating liquidity, and to maintain assets using valuation assessments that looked at the true conditons for the debt according to time and present  value (mark to market). 

 

As a result of financial firms' lobbying efforts, the rules were eased... eroded by Congressional action... That allowed Fannie (and Freddie) to operate with more freely, and to make risky decisions that now have resulted in the reported book assets being valued at much more than they are actually worth.

 

That in a nutshell, (without explaining CDO's, Credit Derivative Swaps and a few dozen more exotic financial instruments) is about what happened.   Because the mortgages were sliced, diced, insured, re insured and revalued by questionable mathematical formulas, the actual value is almost impossible to fairly evaluate. 

 

Almost for certain, the amount at risk is many times the $500Billion that the government has estimated.  Some of the Conservative economists who really understand the situation have estimated the actual loss to be about  $1.3 Trillion .  Depending on the length of time before the markets begin to agree to trade the questionable assets ... the actual  losses could possibly reach as much as $3 Trillion Dollars... and that is just for Fannie Mae and Freddie Mac .

 

Now for the final nail in the coffin... With the Government now having agreed to "back" the assets, so that the Sovereign Wealth Funds, Pension Funds, and Brokerage Houses won't have  take a loss on their investment... The final result could be debt of $1 to $2 Trillion dollars to be paid for by the US Government... That's you and me.

 

At this rate, the individual personal debt of each and every American (our part of the Federal Debt), could go from today's $32,000 to somewhere between $34,000 and $36,000.

 

Yes... In order for Uncle Sam to pay off in full on  those investments in Freddie and Fannie (which normally would be at risk to the investors...), every US citizen (man woman and child) is going to have to kick in $2,000 to $4,000.  

 

For the next big dollars that you're going to have to pay out of your future, watch the FDIC, which will pay off when the banks go belly up, and the Pension Benefit Guaranty Fund,both of which are already "Broke". 

 

No one has yet estimated either of these losses, though a year ago, the Pension Funds were in the red by about $600 Billion Dollars. It looks as though about 100 banks may close by the end of this year, and I've heard that as many as 1,000 are on the near time "watch list".  Wouldn't dare estimate these losses

 

.. and that doesn't even take into consideration hyperinflation, depression, or global warming...   :-) :-) :-) 

 

Thank your congressmen for the way they've protected your interests. 

 

my opinion only

 

Guest's picture
Guest

Propping up F&F to keep mortgage rates artificially low is an effort to bring a rapid end to price declines in housing.

However, housing is still generally unaffordable on a historical multiple of income basis, so price declines need to continue to restore a normal housing market.

If not, I expect enormous political pressure on these now government-controlled mortgage lenders to lend with very low downpayments to keep the loans flowing.

A California house that sold in 2003 for $200,000 still is not worth $450,000, even if you can borrow for 30 years at 5.5% with only 5% down (or 0% if you are a member of a politcally active "disadvantaged" group)

Guest's picture
Suz

I'm worried about the long term effects of this bailout and whether it will make the recession (are we officially using this word yet?) last longer than is normal for an economic re-adjustment.

-Suz

Guest's picture
Darren

Very nice and intelligent comments. Thank you for helping me better understand this mess we are in.

I do agree overall the true core issue is how we as consumers operate. Buy now and pay later is the culprit.

What happened to the depression era value I was taught by my Grandfather and Dad about save now then buy?

I agree the prices for homes and especially education in our country are ridiculous.

Financial education is so poor in this country it's sickening.

When people think "How much is this going to cost me monthly"? have already failed Financial 101.

I dare you to ask the "normal" citizen to explain future/present value. I'll save you the headache. They can't...

I don't know why the U.S. government feels so compelled to make good an investment where the foreign countries involved should know the risk. Nothing is a "sure thing". If China put's their eggs all into one basket like many others have done in the America sector(retirements, pensions) they too should feel the pain regarding that risk.

Default would be the best way to to start fixing a fundamental problem in the economy; both in the U.S. and worldwide.

Guest's picture
Greg

I have a friend that was/is a victim of the Katherina storms and lost everything. I can't help even help him and I have a job and I may need to sleep in my 43 day behind car note car so I can not miss work. Who has enough money to purchase a WOODEN TOY ARROW.

Guest's picture
Guest

naive question...
it would be smart to invest in fannie or freddie right now, correct? say $500 and not look at it for 5 years??