Monday, April 21, 2008

Fannie Mae And Freddie Mac: Will They Need A Bailout, And At What Cost?

I read an article this morning in CNNMoney that discussed the potential for a Fannie Mae and Freddie Mac bailout that I thought I’d share. For those who aren’t familiar with the companies, Fannie Mae and Freddie Mac are government-sponsored entities which help stabilize the mortgage market by purchasing mass quantities of loans and packaging them into securities. With the credit markets in disrepair, the importance of these two companies has increased dramatically. According to the article, 82 percent of U.S. mortgages are being backed by one of the companies, up from 46 percent in the second quarter of 2007. With the value of real estate continuing to decline, the mounting losses and increased exposure of the two companies could lead to disaster. The government can’t and won’t let these companies fail--and will come to their rescue if necessary. The price tag of a potential bailout could be more than $1 trillion dollars, along with additional ramifications to the U.S. economy. Let’s look at some of the warning signs and potential outcomes as described in the CNNMoney article:

Risks and warning signs

“...other experts expect that declining home values will force more borrowers who have a Fannie- or Freddie-backed loan to stop making payments in the coming months, rather than continuing to make payments on a home now worth less than their loan balance.”

“Rising job losses may also make it difficult for other borrowers who formerly had good credit to stay current on their mortgage payments.”

“Some economists suggest that if investors start to see problems in the performance of loans backed by Fannie and Freddie, they'll dump them. And that would force the federal government to step in.”

“’I would say there's at least a 50-50 chance of some sort of bailout. I'm not saying it will necessarily cost $1 trillion, but they'll need some kind of help, and it very well could happen this year,’ said Dean Baker, co-director of the Center for Economic and Policy Research”

“The yield premium for securities backed by Freddie and Fannie compared to the yield on Treasury bills has grown to about 2.25 percentage points from 1.7 percentage points at the beginning of the year. That's a sign that the investors see a greater risk of Fannie and Freddie running into bigger problems.”

“OFHEO, in its annual report this week, said that while Fannie and Freddie have made progress clearing up accounting problems that had dogged both firms, they remain ‘a significant supervisory risk.’”

“...since current home price declines are without precedent, the firms will have a difficult time correctly pricing the risk of the mortgages they're backing.”

“...Fannie and Freddie's role in the mortgage and real estate markets is likely to grow, as Congress recently allowed them to back larger mortgages, up to $729,750, up from the previous limit of $417,000.”

“The Office of Federal Housing Enterprise Oversight (OFHEO), which regulates both firms, also recently lowered the capital requirements for Fannie and Freddie in an effort to pump $200 billion more into the credit markets.”

“The new loan limits will increase the risks and losses for Fannie and Freddie, said Wagner and other experts.”

“The high priced markets where homeowners and buyers need larger loans are now the ones seeing steep home price declines. And the default rates on larger loans are greater than the smaller loans that had previously been the core of their business.”

Potential costs for a bailout

According to the article, Standard and Poor’s predicted a bailout out of the companies could cost between $420 billion and $1.1 trillion dollars of taxpayer money—a cost so high that it puts the U.S. government’s AAA credit rating at risk. This has potentially enormous ramifications, because the lowering of the government’s credit rating would mean the cost of borrowing money would go up and the number of potential investors interested in buying U.S. treasuries would go down. Since the U.S. is financing its extravagant lifestyle with debt, if our ability to borrow decreases significantly we are going to have to make serious changes as a nation.

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