What Happens If Fannie Mae And Freddie Mac Fail?

The new economic stimulus plan includes a provision that will allow for a one-year increase in the conforming loan limits of Fannie Mae and Freddie Mac. I talked a bit about this in a previous post: Fannie Mae and Freddie Mac Loan Limits To Rise In Economic Stimulus Package. Seeing that this new legislation will allow Fannie Mae and Freddie Mac to purchase riskier loans, I thought it would only be fair to discuss what would happen if either of these companies were to fail.

Fannie Mae and Freddie Mac are publicly traded companies, meaning that anyone can buy shares of the companies. However, not everyone realizes these companies are also essentially government backed: That means for all intents and purposes the U.S. government, although not technically required to do so, will ultimately cover the debt of Fannie Mae and Freddie Mac. The U.S. government--actually the U.S. taxpayers--would bail them out. I happened across a document that spoke to this point released by the Republican Policy Committee, which said the potential cost to U.S. taxpayers in the event that one or both of these companies failed could be in the hundreds of billions of dollars. “The implicit guarantee causes investors to continue to loan to Fannie and Freddie despite these risks because of the expectation that the Treasury would come to their aid in a crisis," the document said. "This encourages the management at Fannie and Freddie to take on more risk and more debt than they otherwise would.”

Those who can remember back few years will recall the major accounting scandals at these companies, which doesn't exactly reinforce trust in the management of these companies. In addition, these companies are already experiencing financial problems stemming from the credit crisis, and as a result have had to raise additional funds through stock offerings and dividend cuts. Now we are going to allow them to make additional risky jumbo loans. Are we sure this is the best thing for these companies and the U.S. taxpayers?

For people who live in the high-cost areas which stand to benefit from the increased loan limits, this legislation is still probably good news. The chances that the increased limits will stimulate local real estate markets is probably better than the chances that tax payers will have to bail out of either of these companies because of problems with the new loans. However, for people living in lower-cost areas--a vast majority of the U.S. population--this legislation is all bad news. They won’t receive any benefit but will still have to chip in tax dollars in the event of a bail out. Granted, high-cost areas were not getting their fair share prior to this change, since most people couldn’t qualify for conforming home loans because of the high price of real estate.

Regardless of where people live--whether a low-cost or a high-cost area--they should be worried about the potential for failure of Fannie Mae and Freddie Mac. There were already problems in both companies, and the increased loan limits add another potential fire. Hopefully management of these companies doesn’t get too crazy with the idea of increased revenue possibilities, or succumb to government pressure, and remembers to make wise business decisions. I will not be holding my breath.