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July 15, 2008

The Panic Over Fannie and Freddie

David Beim
Professor of Finance and Economics and Bernstein Faculty Leader
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The U.S. government has made it clear that Fannie Mae and Freddie Mac, the two big mortgage guarantors, are not going to run out of cash. Yet the stocks of both are still tumbling; what is going on?

The issue is equity capital. Both institutions are seriously undercapitalized compared to their risks. The right solution is to issue more capital, lots of it. But the price of both stocks is very low, so lots of new capital implies major dilution of the old capital. The more the stocks fall, the more dilution new capital implies; and the more dilution is anticipated, the more the stocks fall. It is a vicious circle.

The basic facts about capital and risks are simple and stark:

Fannie Mae Freddie Mac
Capital $48 billion $27 billion
Total Mortgage Portfolio
(including guarantees)
$2,968 billion $2,013 billion
Ratio 1.6 percent 1.3 percent

For comparison, commercial banks are required to hold a minimum of 8 percent capital against their risk assets, and most choose to hold at least 10-12 percent.

Both Fannie and Freddie insist they are in compliance with the statutory and regulator-imposed capital requirements. That is true. The trouble is that neither institution has ever been required to hold a level of capital appropriate to their risk, and that is now coming home to roost.

Once an institution is in financial stress, it is very hard to sell equity capital because the price falls and stock buyers become frightened. The time to sell new issues of stock is when things are going well. As with friends, the time to make friends is when you don’t need them.

Raising capital is not impossible, just very slow and painful. Fannie Mae raised $7 billion of new capital in the second quarter. But the above table makes it clear how very much further both companies have to go.

Is government the solution? The last thing we need is for government to take over the two institutions. Some people are advocating this because they say that private ownership is a sham. But it is not a sham — real investors are losing real money here, and real investors can put pressure on managements to behave responsibly.

If government were to take full control of Fannie and Freddie, you can be sure that both institutions would soon own the entire subprime crisis. Politicians could not resist forcing both institutions to lower their standards so far that they absorbed everyone else’s mistakes. Even though some of this is going on, it is small compared to the total of subprime assets. Fannie and Freddie are prime lenders/guarantors and should remain so. They have trouble enough without taking on the nation’s subprime portfolio.

Rather, the government should begin by raising both companies’ capital requirements. It then might purchase a large issue of nonvoting preferred stock in each to help meet such requirements. The nonvoting feature would help to suppress political intervention. If the preferred carried an appropriate dividend, the government might someday sell it to the public after the present crisis has passed.

Fannie and Freddie are a mixture of public and private interests; the public interest is to preserve liquidity for prime mortgages. They should not be tools to bail out imprudent subprime lenders — they should be preserved in their present state with adequate capital.

Comments

by Osifo Akhuemonkhan | July 15, 2008 at 9:15 PM

Professor Beim's analysis is spot on, so is Lawrence Kudlow. Safe for the fact that Mr. Kudlow's analysis of the situation is artfully bellowed evening after evening on CNBC, his grievances about the government's "socialist" moves in the past few months are valid. The government is setting a precedent in these turbulent times, a wrong one at that. What factors determine who is offered this line of credit? Why was IndyMac of California unworthy of the same convenience? Where or when will the line be drawn? In business, especially as practiced in a capitalist society, you lose when you make crucial errors like the one some of these financial institutions have made. Saving GSEs like Fannie and Freddie is tolerable and was expected cause after all, they are GSEs. But as for the others....I think the fed should let the free markets determine the outcome, the financial industry will be stronger for it. Its not as if the line of credit is helping the stockholders, in all these cases the stock value has already plummeted before the fed steps in. Then again, loosing 95% is always better than loosing 100% of an asset's value.

by Brad | July 16, 2008 at 12:21 AM

It may be true that Fannie Mae and Freddie Mac have never been required to hold a level of capital appropriate to their risk, but the "basic facts" about capital and risk may not be so basic. Commercial banks are indeed required to hold a minimum of 8% capital against their risk assets, as the author notes. More specifically, banks are required to maintain a minimum risk-based capital ratio (risk-based capital to risk-weighted assets) of 8%. To be considered "well" capitalized, commercial banks must maintain a risk-based capital ratio of at least 10%. Risk-based capital includes hybrid and subordinated debt instruments that receive partial equity credit from rating agencies and bank regulators. To my knowledge, GSE core capital only includes common equity (excluding AOCI), additional paid-in capital, retained earnings, and non-cumulative perpetual preferred stock. To be clear, hybrid and subordinated debt are not included in GSE core capital. My point is that the comparison between bank risk-based capital and GSE core capital is not apples-to-apples. Additionally, the author compares the GSEs' core capital to their total mortgage portfolios, not risk-weighted equivalents as in the banks' risk-based capital ratio. So again, the comparison is not apples-to-apples.

by Dan Kim | July 16, 2008 at 12:37 PM

I agree with Brad. To add to his point, the majority of "total mortgage pf" that author points out is guarantees that are off-balance sheet. While these are genuine exposures, it's credit risk on very well defined and regulated asset class "conforming loans" compared to commercial banks taking interest and credit risk on broader asset class albeit mostly AAA. Furthermore, it's hard to argue the fact that GSEs have far better access to debt capital than any commercial banks out there even in most realistic distress scenarios, which further justified the lower cap reqmnt. My personal opinion is that imposing regular commercial banks' capital requirement on GSEs seems excessive.

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