Fannie, Freddie breakup floated

July 15, 2008 5:00:27 PM PDT
The troubles at Fannie Mae and Freddie Mac could herald major changes for the two giant mortgage finance companies, and for the entire U.S. mortgage funding system. As Fannie and Freddie stumble, financial analysts and public policy experts alike are flush with talk about whether they should be merged, broken up, scaled back or taken over by the government. All of these possibilities highlight an important - and unanswered - question: What's the best way to provide cash for the strapped U.S. mortgage market?

"They cannot continue in their current form," said Armando Falcon, who served for six years as the companies' chief government regulator and frequently clashed with the companies. "It's going to either have to be a wholly government function or the government will have to develop a market...that is much more competitive."

One idea, floated by Ladenburg Thalmann analyst Richard X. Bove, is for the government should create a new agency to buy both Fannie Mae and Freddie Mac, and then distribute their holdings to 12 government-created banks around the country.

Those regional banks would be owned by thousands of local lenders, much like the 8,100 member Federal Home Loan Bank system, which also provides money for mortgage lending. The federal government would set standards for loans made under the new system.

However, a government takeover would be a tremendous hit to shareholders, who have seen the value of their shares sink more than 60 percent since the start of the month. The companies also have long had powerful allies in Congress, and top Democrats appear more likely to keep Fannie and Freddie in their current form.

"The path of least resistance in Washington will be to keep them intact and put a tighter rein on them," said Edward Yardeni, an economist who runs Yardeni Research in Great Neck, N.Y.

Fannie and Freddie were created by the government to provide more Americans the chance to own a home. The companies buy mortgage loans from banks, thereby increasing the cash banks have on hand to lend to other borrowers. While the companies operate under a government charter, both are owned by shareholders.

They are tremendously important to the housing market and overall economy, because they either hold or guarantee $5.3 trillion of mortgage debt, or about half the outstanding mortgages in the United States.

Testifying on Capitol Hill on Tuesday, Treasury Secretary Henry Paulson said the Bush administration has no immediate plans to extend emergency loans to Fannie Mae and Freddie Mac or to purchase the stock of the two companies, though it is seeking the power to do so if necessary.

Any government financial backing of the two institutions would be done "under terms and conditions that protect the U.S. taxpayer," Paulson said. But Sen. Jim Bunning, R-Ky. was upset with the rescue package unveiled Sunday, saying Paulson "is asking for a blank check to buy as much Fannie and Freddie debt as he wants - for this unprecedented intervention in our free markets."

The administration is hoping that Congress will quickly pass legislation needed to put parts of its rescue proposal into effect.

Shares of Fannie and Freddie tumbled again Tuesday as investors began to accept their holdings might be wiped out by the government's plans.

Fannie Mae shares fell $2.66, or nearly 27.3 percent, to $7.07, while Freddie Mac shares declined nearly $1.85, or 26 percent, to $5.26 amid continuing fears that investors will be wiped out by the companies' woes, or by a federal bailout. Stock market investors "don't know where they fit anymore," Friedman, Billings, Ramsey & Co. analyst Paul Miller said.

Bert Ely, an Alexandria, Va., banking industry consultant and longtime critic of the two companies, said Fannie and Freddie could well see their mortgage activities severely restricted. That's bad news for Fannie and Freddie executives who have long pushed to expand the companies' mortgage holdings.

"They have lost hugely," Ely said. "I'm not sure how well that's fully sunk in with people."

Meanwhile, the Federal Deposit Insurance Corp. on Tuesday approved new regulations as part of a government effort to jump-start a U.S. market for "covered bonds," a way of packaging mortgage investments that is designed to encourage more responsible lending practices.

Those bonds are issued by banks and backed by mortgages or cash flows from other debt. Under this concept, widely used in Europe, banks guarantee the bonds if too many borrowers default, thus providing an incentive for less risky lending practices.

Plus, unlike formerly popular subprime mortgage securities backed by loans made to borrowers with weak credit records, the mortgages remain on the balance sheet of the bank that sells the bonds.

Encouraging such a market to grow could be one way to decrease the dominance Fannie and Freddie wield in the U.S. mortgage market.

Their role in the U.S. mortgage market, has grown dramatically over the past year after the subprime mortgage market's collapse. The companies issued about three-quarters of all new mortgage-backed securities in the second quarter of 2008, up from under 40 percent in 2006, according to trade publication Inside Mortgage Finance.