We now own Fannie and Freddie

The Federal Housing Finance Agency (FHFA) has just placed Fannie Mae and Freddie Mac into conservatorship with investment and guidance from the Treasury. This action is taken in coordination with the Federal Reserve.

It appears the Treasury is going to invest $100 billion each into Fannie and Freddie.

A bit of background:

• Fannie Mae and Freddie Mac hold over $5 trillion in US mortgage-backed securities, almost half of the $12T total.
• Fannie and Freddie currently have about $1.6 trillion of debt, owed mostly to large, often foreign, investors.
  
• Fannie and Freddie both raised capital in recent stock offerings ($14.4B and $6B, respectively), but this capital is being eaten away by the massive losses it is taking on the mortgage-backed securities it owns.
  

From the FHFA's conservatorship fact sheet:

A conservatorship is the legal process in which a person or entity is appointed to establish control and oversight of a Company to put it in a sound and solvent condition. In a conservatorship, the powers of the Company’s directors, officers, and shareholders are transferred to the designated Conservator.

Conservatorship is basically Chapter 11 for organizations "too big to fail."

FHFA was formally established Sept 3, 2008 (3 days ago) by combining two other government agencies.

The deal appears to be structured in a way that the Treasury has not assumed the $1.6T debt of Fannie and Freddie. Whether the market believes this debt is going to be backstopped by the Treasury is another matter.

This 'bail-in' is remarkably similar to similar actions taken by the International Monetary Fund and the Treasury to combat financial crises in Mexico in 1992 and Asia in 1997. The main difference is that today's actions are much larger -- $200B compared to maybe $100B for Asia, which was lent by the developed world via the IMF -- not just the U.S..

The general idea here is that Fannie and Freddie must survive because they play a critical role in the US mortgage market liquidity. Failures by the mortgage market-makers would literally freeze the housing market -- no selling or buying at any price unless you're paying cash.

What do Fannie and Freddie do, exactly?
Fannie and Freddie improve market liquidity by:

1. buying individual mortgage loans from the primary lender (Chase Mortgage, for example)
2. packaging individual mortgages into larger collections called mortgage-backed securities or collateralized-debt obligations with certain risk-reward properties
   
3. selling these securities back to commercial and investment banks, but also to sovereign wealth, real-estate, pension, and hedge funds

The effect of this is that the primary lender does not have to hold the mortgage it lent on its own books. Whether this promotes lax lending practices as epitomized by no-doc, no-down, interest-only, teaser-intro-rate loans is an exercise left to the reader.

What did Fannie and Freddie do wrong?
Fannie and Freddie got into trouble by investing their own capital in these mortgage-backed securities because they saw all their large-investor customers making money hand-over-fist during the housing bubble.

They literally drank their own Kool-Aid.

Compounding this problem is that Fannie and Freddie were/are Government Sponsored Entities (GSEs). The trouble is that GSEs are strange public-private beasts and though technically their debt is not backed by the government, many in the market sort of believed it was. This meant investors were willing to lend Fannie and Freddie very large sums of money at close-to-Treasury rates. The T-bill is one of the world benchmarks for safe money. Fannie and Freddie took this money and bought the far-from-safe-MBSes it was selling.

W. T. F.

What's Treasury (You) doing?
Just to re-iterate, Fannie and Freddie own almost half of the U.S.' mortgage assets.

Now the Treasury (this means you and your taxes) is trying to clean up the mess by giving them $200B and a plan. Treasury Secretary Paulson appears to be doing a pretty good job managing this mess. The capital infusion comes with real provisions to protect taxpayers and restructure the way Fannie and Freddie do business, which was a key to success in the Mexico and Asian bail-in.

The responsibility to execute this plan and to prevent further occurrences of this kind of problem fall to the next President -- be sure to ask your candidate about it.