What Was the Fannie Mae and Freddie Mac Bailout?

Fannie Mae and Freddie Mac Bailout
Falling housing prices caused the bailout of Fannie and Freddie. (Photo: David McNew/Getty Images).

The Fannie Mae and Freddie Mac bailout occurred on September 17, 2008. The U.S. Treasury Department was authorized to purchase up to $100 billion in their preferred stock and mortgage-backed securities (MBS). As a result, they were put into conservatorship by the Federal Housing Finance Agency (FHFA). Keeping the two afloat cost taxpayers $187 billion over time, making it the largest bailout in U.S. history.

 

 In 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 interest. (Source: "A Rescue That Has Come With Claws," The New York Times, December 13, 2015.)

The Fannie and Freddie bailout was greater than the 1989 Saving and Loan Crisis, which "only" cost the taxpayers $124 billion. It was on par with the subsequent bailout of AIG, which started at $85 billion but grew to $150 billion. Both were small potatoes compared to the $700 billion bailout of the U.S. banking system -- even though only $350 billion of that was ever spent. 

The bailout kept Fannie, Freddie, and the American housing market, functioning. It was supposed to be temporary, but economic conditions never improved enough to allow the government to sell the shares it owned and return Fannie and Freddie to private ownership.

What Led to 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.

They packaged these into mortgage-backed securities, and resell them to investors on Wall Street. The entire financial system is built on trust. That trust was shaken by the Subprime Mortgage Crisis.

Fannie Mae and Freddie Mac were two government-sponsored enterprises (GSEs) that created, and remain highly involved in, the secondary market for mortgage-backed securities.

Before the subprime mortgage crisis, they owned or guaranteed $1.4 trillion, or 40%, of all U.S. mortgages. They only held $168 billion in subprime mortgages -- but it was enough to capsize the two. Find out how the two GSEs supported the secondary market, which helped American families realize the dream of homeownership. More important, here's how that turned into the nightmare of the subprime mortgage crisis, led to the 2008 financial crisis, and ultimately caused the Great Recession.

The government tried to avoid taking over the two GSEs, which were supposed to act as private corporation with a government guarantee. That set-up didn't work, and was part of the problem. Fannie and Freddie took excessive risks to boost their stock prices, knowing they would be bailed out if the risks turned south. 

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%. (Source: Fannie Mae Web Site, "Fannie Mae Will Not Issue Benchmark Notes in August," 8/20/07; The Economist, The cracks are spreading, 11/21/07)

On March 23, 2008, Federal regulators unwisely agreed to let Fannie and Freddie take on another $200 billion in subprime mortgage debt. This was despite the fact that 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.

On March 25, 2008, the Federal Housing Finance Board agreed to let the regional Federal Home Loan Banks take an extra $100 billion in mortgage-backed securities for the next two years. These loans were also guaranteed by Fannie and Freddie. In just a week, the two GSEs had $300 billion in bad loans added to their already shaky balance sheets. This was also after 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.

On 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.

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. However, the $25 billion guarantee was more to reassure investors -- and 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 Fannie and Freddie were nationalized and their investments equaled zero.

Wall Street's fears that the loans would default sent Fannie's and Freddie's shares plummeting. This made it impossible for the 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 (FHA) 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. (Source: Associated Press, House OKs rescue for homeowners, Freddie, Fannie, July 23, 2008)

Treasury Secretary Paulson was the major force behind the bailout. He wanted to reassure financial markets that the banking system was solid 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, 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. (Source: AP, "Paulson Braces Public for Months of Tough Times", July 21, 2008)

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. However, 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.

That forced to nationalize Fannie and Freddie. That's because the two Government Sponsored Entities (GSE's) are now private companies, and rely on the sale of stocks and bonds to finance their operations, just like any other corporation. If they can't sell their bonds, which are mortgages, then they may run out of capital to buy more mortgages. That would jeopardize any housing recovery.

Nationalization meant the Treasury would take over the GSE's entirely, essentially wiping out stockholders' wealth. Fannie and Freddie's stock prices were declining due to fears of nationalization. That only made it harder for the GSE's to raise capital, thus making 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. (Source: WSJ.com, Deflating Mortgage Rates, August 20, 2008)

However, many banks were still in jeopardy, since they also owned much of the $36 billion in preferred shares of Fannie and Freddie. These became worthless when the government took the next step, putting the GSEs into receivership. (Source: CNN Money,  Government Seizes Fannie and Freddie, September 7, 2008)

The Federal government stepping 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. In fact, 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 has created a flight to safety. When the world is in turmoil, the dollar looks strong, despite the high debt-to-GDP ratio of the U.S.