The Biggest Wedding of the Year?

The latest word is that perhaps the best way to solve the problems of two separate but similar entities is to have them joined. With Minister Paulson as the master of design, it’s quite possible that Freddie Mac and Fannie Mae will be united in what may be the biggest wedding of all time.

As foster mother, OFHEO failed to live up to her motherly obligations and now we have Freddie and Fannie running rampant and causing all types of havoc. With plans to have the ceremony at the White House, the reception on Capitol Hill, and the honeymoon at the Treasury, you would think the two crazy kids would have gotten hooked a long time ago. The Treasury, after all, does print the money you know! (See Below)

There has been talk about the possibility of merging Fannie Mae and Freddie Mac. How and when that would happen is still a mystery. But one thing is certain. The failure of one or both of these Government Sponsored Entities (GSE) would be disastrous. If one of these GSE’s fails, we could assume that the same forces will cause the other GSE to fail, in essence, making the mortgage market all but shut down in the near term.

Fannie Mae and Freddie Mac were established to make homes more affordable for lower and middle income Americans. They are both ‘sponsored’ by the US government but the implications of that have become dubious at best. Neither provides home loans, but each one stands ready to buy mortgages from banks in order to take them off the banks’s books and provide the bank with capital to make additional loans. In some cases, the GSE’s don’t buy the mortgages, but provide a guarantee in the event of default. They currently hold or guarantee roughly half of the $12 trillion market in mortgages making it clear that their failure would be much worse than the failure of Bear Stearns would have been.

For many years, critics of the two firms pointed to their sheer size and business practices and felt that they were both too big and unregulated. They were both extremely risky, some said. Their size didn’t happen by mistake, however. Over the years, both firms lobbied hard to pass legislation that allowed them to remain independent, grow rapidly, and remain unregulated. As the connection between the GSE’s, Wall street, mortgage bankers, real estate agents, and lawmakers became tighter, both Fannie and Freddie became profit drivers for the above-mentioned constituents, which made sure that the status quo held firm. Both firms had members of their board who were tied to political power-players and they hired well connected lobbyists to protect their interests. In the early 90’s the Office of Federal Housing Enterprise Oversight (OFHEO) was made regulator for both Fannie and Freddie, but we now know that OFHEO was a weak regulator.

So what went wrong? Since Fannie and Freddie owned or guaranteed roughly half of all outstanding mortgages, the subprime meltdown and subsequent effects has had a detrimental effect on the value of the assets they hold. As foreclosure rates rise, they are on the hook for those mortgages and the mortgages they hold, and which are now trading at much lower levels. It moves them closer to violating their minimum capital requirements and making them look insolvent. As a matter of fact, by general accounting standards, if their assets were marked-to-market (priced at what current buyers are willing to pay), some economists say they are already worthless!!

Since banks and other lenders rely on Fannie and Freddie to buy their mortgages in order to free up capital and make more mortgages, the elimination of either or both of the GSE’s will freeze up the housing market through ever tightening bank standards. Already, even the most qualified borrowers are facing less favorable loan terms.

Now, Treasury Secretary Hank Paulson is considering all possible options, along with Ben Bernanke and a few others. One possible scenario was a merger of the two to form one larger, more stable firm, but this would be highly unlikely. Besides the uncertainty of whether a merged firm will emerge stronger than the sum of it’s parts, it doesn’t address the risks inherent in the business model. Risks that are surfacing now: that perhaps these agencies got too big!

There is also the possibility of further regulation, in the form of higher capital requirements or limits to lending standards. For some, this would be a natural step since both Freddie and Fannie have always been free-wheeling children of the US Government. The least that the US government could do is give the agencies a curfew.

Finally, one or both agencies can be placed in a conservatorship. In this scenario, their shares would be worthless and you, me, and the rest of the taxpayers will pick up the tab. A conservatorship has quite a bit of flexibility to overhaul the agencies but cannot close them. What will come out of this will surely be some form of consolidation and distribution. Perhaps a smaller, combined entity can fulfill it’s purpose within a system that will eventually shift risk to the private sector. It would be a huge undertaking and could take a decade or longer to complete.

When it’s all said and done, we should end up with a structure that on the surface looks less risky. But rest assured that financial innovation will someday challenge the limits of even the most well thought out solution.