The Fannie Mae and Freddie Mac bailout occurred September 6, 2008. The bailout came as the U.S. Treasury Department was authorized to purchase up to $100 billion in preferred stock of the organizations and buy mortgage-backed securities. As a result, Fannie and Freddie were put into conservatorship by the Federal Housing Finance Agency (FHFA).
The Bailout Cost to Taxpayers
According to an independent economic group, the Shadow Open Market Committee (SOMC), keeping the two agencies afloat cost taxpayers US$187 billion over time as the Treasury paid $116 billion for Fannie and $71 billion for Freddie.
As The New York Times reported, August 2012, the Treasury decided it would send all Fannie and Freddie profits into the general fund. Since then, the bailout has been paid back with an additional $58 billion in profit, again reported by SOMC. Fannie remitted $147 billion, and Freddie paid $98 billion.
The Fannie and Freddie bailout was greater than the 1989 saving and loan crisis, which cost the taxpayers $124 billion. It was on par with the subsequent 2008 bailout of AIG, which started at $85 billion but grew to $182 billion. Both were small potatoes compared to the 2008 $700 billion Troubled Asset Relief Program (TARP) bailout of the U.S. banking system, even though the U.S. Treasury shows only $439.6 billion of TARP funds were ever spent.
The bailout kept Fannie, Freddie, and the American housing market functioning. It was supposed to be a temporary situation. But economic conditions never improved enough to allow the government to sell the shares it owned and return Fannie and Freddie to private ownership.
Building a House for the Bailout
Fannie Mae and Freddie Mac were two government-sponsored enterprises (GSE) that bought mortgages from banks, a process known as buying on the secondary market. These purchased loans were then repackaged into mortgage-backed securities (MBS). The MBS were, in turn, sold to large, institutional investors on Wall Street. At times these firms would themselves repackage the mortgages into securities where were sold to smaller investors.
These investments were in great demand because they returned a high-interest income to the investor. Loans continued to be sold, repackaged and resold as banks competed with one another to write more and more mortgage loans to often under- or unqualified buyers. The entire financial system depends on trust. The subprime mortgage crisis decimated it.
Fannie Mae and Freddie Mac remain highly involved in, the secondary market for mortgage-backed securities as they continued to help American families realize the American dream of homeownership. Before the subprime mortgage crisis peaked in 2008, they owned or guaranteed $1.4 trillion, or 40 %, of all U.S. mortgages. While the two entities held only $168 billion in subprime mortgages, it would prove to be enough to capsize them. The dream turned into a nightmare and led to the 2008 financial crisis and caused the Great Recession.
The government tried to avoid taking over the two GSEs, which were supposed to act like private corporations with a government guarantee. However, that set-up was flawed and became a part of the problem. With a lack of self-control, Fannie and Freddie took excessive risks to boost their stock prices, knowing they would be bailed out if their risky practices turned south.
Fannie and Freddie Debt Offering
Before the subprime meltdown, the two GSEs continued to ratchet up their debt holdings. In August 2007, Fannie Mae announced it would skip a benchmark debt offering for the first time since May 2006. Investors rejected even the highly-rated mortgage-backed securities offered by the GSEs. Most investors thought Fannie had enough cash to allow it to wait until the market improved. By November 2007, Fannie declared a $1.4 billion quarterly loss and announced it would seek $500 million in new funds. Freddie then disclosed a $2 billion loss, sending its stock price down 23%.
March 23, 2008, federal regulators unwisely agreed to let Fannie and Freddie take on another $200 billion in subprime mortgage debt. The two GSEs were desperately trying to raise enough cash to keep themselves solvent. Everyone at the time thought the subprime crisis was restricted to real estate and would correct itself soon. Perhaps they didn't realize how derivatives had exported the subprime mortgage defaults throughout the entire financial world. As it turned out, this was another $200 billion the government had to bail out later that year.
March 25, 2008, the Federal Housing Finance Board agreed to let the regional Federal Home Loan Banks take on an extra $100 billion in mortgage-backed securities for the next two years. Fannie and Freddie guaranteed those loans as well.
In just a week, the two GSEs had $300 billion in bad loans added to their already shaky balance sheets. The Federal Reserve agreed to take on $200 billion in bad loans from dealers (actually, hedge funds and investment banks) in exchange for Treasury notes. Last, but certainly not least, the Fed had already pumped $200 billion into banks through its Term Auction Facility. In other words, the Federal government had guaranteed $730 billion in subprime mortgages, and the bank bailouts were just getting started.
HomeStay and HomePossible Programs
April 17, 2008, Fannie and Freddie made further commitments to help subprime mortgage holders keep their homes. Fannie Mae developed a new effort called HomeStay, while Freddie modified its program called "HomePossible." Those programs gave borrowers ways to get out from under adjustable-rate loans before interest rates reset at a higher level and make monthly payments unaffordable. Unfortunately, it was too little and too late.
Investing in Shares of Fannie and Freddie
On July 22, 2008, U.S. Treasury Secretary Henry Paulson asked Congress to approve a bill allowing the Treasury Department to guarantee as much as $25 billion in subprime mortgages held by Fannie and Freddie. The two GSEs held or guaranteed more than $5 trillion, or half, of the nation's mortgages.
The $25 billion guarantee was more to reassure investors. It didn't work for long. Wall Street investors continued to pummel the GSEs stock prices, to the point that they couldn't raise the cash needed to pay off the loan guarantees they held. Wall Street was savvy enough to realize that a $25 billion infusion by the Federal government wasn't going to be enough. Stockholders wanted out before the government nationalized Fannie and Freddie and made their investments worthless.
Wall Street's fears that the loans would default sent Fannie's and Freddie's shares plummeting. It became impossible for private companies to raise the additional capital needed to cover the mortgages. Most people don't realize that the July bailout also included:
- $3.9 billion in CDBG grants to help homeowners in poor neighborhoods.
- Approval for the Treasury Department to buy shares of Fannie's and Freddie's stock to support stock price levels and allow the two to continue to raise capital on the private market.
- Approval for the Federal Housing Administration to guarantee $300 billion in new loans to keep 400,000 homeowners out of foreclosure.
- About $15 billion in housing tax breaks, including a credit of up to $7,500 for first-time buyers.
- An increase in the statutory limit on the national debt by $800 billion, to $10.6 trillion.
- A new regulatory agency to oversee Fannie and Freddie, including executive pay levels.
Treasury Reassures Investors
Treasury Secretary Paulson wanted to reassure financial markets that the banking system was reliable despite the failure of IndyMac Bank.
Paulson appeared on television throughout the weekend. He warned that the economy would go through months of challenging times. As it turns out, it's been years of challenging times. He admitted, "The three big issues we're facing right now are, first, the housing correction which is at the heart of the slowdown; secondly, the turmoil of the capital markets; and thirdly, the high oil prices, which are going to prolong the slowdown."
However, he added "...our economy has got very strong long-term fundamentals, solid fundamentals. And you know, your policy-makers here, regulators, we're being very vigilant." Unfortunately, they should have been more vigilant years earlier, when the subprime derivatives were being bought and sold in an unregulated market.
Interest Rates Continue Rising
Despite the bailout, mortgage rates continued to rise. By August 22, 2008, rates on a 30-year mortgage were 6.52%. That was a 30% increase since March and the same as a year ago. Rates rose despite a decline in U.S. Treasury bond yields. Those fell as investors fled to the safety of government-backed bonds. (Bond yields fall when demand for the underlying bond rises.)
Fixed mortgage rates usually closely follow that of Treasury bond yields, since the same type of investors like both. Since Fannie and Freddie were in crisis, investors were leery of mortgage products, and have chosen Treasuries instead. Hence, mortgage rates rose, and Treasury yields fell.
Nationalizing Fannie and Freddie
The continued rising of rates forced Paulson to nationalize Fannie and Freddie. Nationalization meant the Treasury would take over the GSE's entirely, essentially wiping out stockholders' wealth. As Fannie and Freddie's stock prices were declining due to fears of nationalization, it only made it harder for the GSE's to raise capital, thus creating a self-fulfilling prophecy.
The other option would be for the Treasury to start injecting large sums of cash to an essentially private company. That would make stockholders happy but continue the precedent set by the Federal Reserve's bailout of Bear Stearns.
Many banks were still in jeopardy since they also owned much of the $36 billion in preferred shares of Fannie and Freddie. As CNN reports, these became worthless when the government took the next step, putting the GSEs into receivership.
Bailout to Stop the Housing Slump
The Federal government stepped in to restore that trust by promising to bail out bad loans. It was meant to keep the housing slump from getting worse. Unfortunately, it was all funded by the U.S. Government, which already had a $9 trillion national debt. The provision to allow the debt level to be raised to over $10 trillion acknowledged who exactly footed the bill for the bailout. Global concerns about the sustainability of U.S. debt kept downward pressure on the dollar. However, the greater threat from the eurozone debt crisis created a flight to safety. When the world is in turmoil, the dollar looks strong, despite the high debt-to-GDP ratio of the United States.
"Fannie Mae Will Not Issue Benchmark Notes in August," Fannie Mae Web Site, August 20, 2007.
"The Cracks Are Spreading," The Economist, November 21, 2007.
"House OKs Rescue for Homeowners, Freddie, Fannie," Associated Press, July 23, 2008.
"Paulson Braces Public for Months of Tough Times," Associated Press, July 21, 2008.