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
|$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.