Taxpayers take on trillions in risk in Fannie, Freddie takeover

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USA Today reports the unprecedented federal takeover of mortgage giants Freddie Mac and Fannie Mae announced on Sunday is a bold attempt to stabilize financial markets and restore the faltering housing market, but it thrusts trillions of dollars of risk directly onto taxpayers’ shoulders.

“You can call it a bailout, you can call it a safety net or you can call it a rescue package, but the bottom line is the American taxpayer is left footing the bill,” says Richard Yamarone, director of economic research at Argus Research. More.

So, what ARE these two mortgage giants?  And why are they important?  How did we get into this mess? And most importantly, how does it affect you?


First, what they are, or rather what they do. Hale “Bonddad” Stewart explained it well enough, but let me paraphrase:

A 100 years ago, a borrower would go to a bank and get a home loan then pay that bank for the 10, 20, or 30 years until the loan was paid off.  Simple enough.  Today, a borrower gets a loan from a lender. Once that borrower closes on their loan, that loan is then sold to a big fish in the financial markets.  Maybe Fannie Mae or Freddie Mac.  Maybe JP Morgan or Citicorp.  They would then keep some of the mortgages and sell others.  The ones they sold were sold as securities; bonds (which other people, companies, pension funds, etc. bought on the open market).

Previously, Fannie Mae and Freddie Mac (both private corporations) had an implied governmental guarantee, for the loans they bought, and then either pooled together and sold or kept.  This allowed them to get better rates on money (than other companies), money that they borrowed and then bought mortgages with.  This arrangement allowed them to grow to be two of the largest business organizations in the world.  Almost 70% of all mortgages in the US are affected by these mortgages.

If you want to read more about these companies, check this out.

Ok, so that is what they are.  Why should you care?

The long and short of it is that many unscrupulous people got into the mortgage business.  They would approve loans without confirming income – in some cases, not even confirming whether people were working, let alone had income – and to the forefront came a variety of mortgage products for people who should not have gotten credit for a mortgage in the first place to allowing people to get mortgages at very low “introductory” rates, which would then “reset” to a higher percentage rate.  Instead of calculating current income to the final adjustment rate, they would give people these introductory rates and tell them that they could then refinance out of those mortgages later, when the resets came.

Unfortunately, it was a big pyramid shell game and many of these people found that they could not refinance, and the monthly mortgage amount became more than they could manage.  Enter foreclosure.  Enter entire neighborhoods of empty houses and all the vandalism and blight that goes along with it.

And then, there is the aspect of the mortgages which were sold as securities.  Many of these were bought by investment banks and houses as part of a portfolio of stocks and bonds for retirement funds, mutual funds, pension funds, etc.

As Bonddad says:

There is also the issue of securitization and the effect it has had on risk management. Financial people had come to think that securitzation insulated loans from risk. Put another way, people thought that the process of securitization so spread out the risk among mortgages with similar characteristics and different institutions who purchased the structured product that the possibility of losses were non-existent.

And therein lies the rub.

Securities are risk.  No matter what, they are a risk  They get a higher return than if you were to put your money into a savings account, but with that higher return comes risk. Unfortunately, the risk which was taken here was problematic for the reason cited above.

The Business Edition says:

Experts are predicting that in the next few years, between 15 and 20 million homeowners could have homes worth less than what they owe. Walking away from a bad situation may actually make sense for people who mortgages that are ‘upside down’ considering the fact that refinancing is out of the question and home equity is nonexistent.

That is a lot of risk.

Oh, and if you care to know where this whole mess started, look to former Senator Phil Gramm (yes, the same one that called you a whiner for saying the economy was in trouble).  Gramm, who is McCain’s “financial guru” was responsible for the Financial Services Modernization Act (also known as the Gramm-Leach-Bliley bill).  Politico stated about this bill:

The general co-chairman of John McCain’s presidential campaign, former Sen. Phil Gramm (R-Texas), led the charge in 1999 to repeal a Depression-era banking regulation law that Democrat Barack Obama claimed on Thursday contributed significantly to today’s economic turmoil.

“A regulatory structure set up for banks in the 1930s needed to change because the nature of business had changed,” the Illinois senator running for president said in a New York economic speech. “But by the time [it] was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.”

(snip)

According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and the Treasury Department about banking and mortgage issues in 2005 and 2006.

During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages.

Is this who you want to be Secretary of the Treasury? McCain has floated his name.

Between McCain saying he was clueless about the economy, and now Sarah Palin adding her inability to understand the whole Fannie Mae/Freddie Mac disaster, I am fearful of how bad our economy could get.

Ok, Ok…why should you care about all of this?  In a word:  Bailout.  No, three words:  Bailout and Taxpayer Dollars.

The takeover of these institutions has been in the works for some time.  After billions and billions of dollars in write-downs (a fancy word for saying to shareholders, buh bye to liquidity), it was deemed necessary to do something to rescue these two organizations.  Here is a timeline of the developments leading to mortgage giants’ takeover.

Once it was determine that the government would move forward with this bailout, Fannie Mae and Freddie Mac will be going into conservatorship. Convervatorship is similar to what happens when a company files bankruptcy.  Someone is taking this company over and in this case, it is the Federal Finance Housing Agency.

A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.

And where do WE come in?

Well, when the Fed takes Fannie Mae and Freddie Mac into conservatorship, it will be with government funds (meaning tax dollars).  Those are same government funds which pay for this war.  And the same funds which are supposed to pay for roads, schools, and other governmental operations. Unfortunately, there are already many, many areas of the country where funds are running out for roads (hello Minnesota bridge failure!) \If you Google “road project funding” you will find stories from around the country of shortages for funding to continue to build and fix roads.

How this is going to affect us remains to be seen But, I will guarantee you this, we will have to see a tax hike to pay for the ongoing economic disaster that George W. Bush has entered us into, and John McCain promises to continue.  After all, China is only going to continue to fund us for so long.

To add some more perspective of this bailout, Ezra Klein had a number of quotes from various economists, including Paul Krugman.

Paul Krugman:

I wish people wouldn’t say that Fannie and Freddie have been “nationalized.” I mean, it’s basically accurate, but it conveys the wrong impression.The fact is that Fannie Mae was originally a government agency; it was privatized in 1968, not for any good economic reason, but to move its debt off the federal balance sheet (and Freddie was created 2 years later as a competitor.) Private ownership of Fannie and Freddie never made any real sense, and was always a crisis waiting to happen.

So what we’re really seeing now is deprivatization. It’s not something like the UK government seizing the steel mills; it’s more like firing Blackwater and giving responsibility for diplomatic security back to the Marines.

To read more on this bailout:

CNN Money: U.S. seizes Fannie and Freddie

This from Hale “Bonddad” Stewart (a fantastic financial blogger).

Bloomberg: Freddie Mac, Fannie Mae Bailout Lowers Mortgage Rates

Mort Zucherman says: We still don’t know where the bottom is.

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One thought on “Taxpayers take on trillions in risk in Fannie, Freddie takeover

  1. I have heard from about three sources that McCain wanted to put our Social Security Funds into sub-prime mortgage investments. Here’s one source:

    http://www.politicalaffairs.net/article/view/7261/1/347/

    “In 2006, McCain voted for the Social Security Reserve Fund, a Republican Party proposal that would shift Social Security’s annual surpluses over to private investment companies – many of the same people who brought you the subprime mortgage crisis and the credit crunch, not to mention the dot.com bubble, oil speculation, and the Enron fiasco – and turned into risky private accounts. “

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