Rumors abound that the U.S. government will, one way or another, step in to guarantee the debt held by Fannie Mae (FNM) and Freddie Mac (FRE), the mortgage underwriters for the country. Why has this possibility arisen? These mortgage corporations hold $3 trillion in mortgage paper. This has been written with a leverage of 100+ to 1. In otherwords, these corporations have put up about $30 million (stock holders equity) and borrowed about $2.97 trillion within the U.S. financial system (which includes international lenders) to buy the mortgage obligations.
This situation has resulted in what is comparable to a margin call. When an investor buys stocks on margin, he puts up part of the purchase price and borrows the rest. U.S. security laws have a margin requirement, a limit on the percentage of stock value that can be borrowed. If the stock purchased on margin falls far enough below the purchase price, the percentage of stock value financed by the margin loan can rise above the maximum value permitted by law. When this happens, the investor receives a margin call. He must then immediately provide more cash or the position will be liquidated by the broker/dealer.
The situation with FRE and FNM is similar in concept to the margin call, but is different the details. The conceptual similarity is that these corporations have bought mortgages, effectively, on margin. Investors around the world have provided the money for the margin, which totals approximately $2.97 trillion. Many of these mortgages have been written with loans at 80% to 100% of the purchase price. Currently, the market value of some of these mortgaged properties have fallen as much as 20% or even more. Thus some of these mortgages are “under water”, i.e. the balance owed by the homeowner is more than the current market value. This produces a situation where the balance sheets for FRE and FNM should show negative net worth. In other words, these corporations should be bankrupt. Technically, they can not be proven bankrupt because there is no transparent market for the mortgages they own. The market value can only be estimated. It should be obvious, however, that the value of each mortgage can not be more than the market value of the underlying property. I compare the current situation to a margin call because it is possible that the market value of mortgaged homes has fallen by more than $30 billion (1%) plus the aggregated down payments. Therefore the $2.97 trillion in borrowed money is probably backed by negative equity. In other words, to adequately secure the debt, more capital must be raised or the debt must be sold to repay the lenders. I refer to this as the FNM/FRE margin call.
What can happen now? One possiblity is nothing. This would be disaster for the reeling U.S. financial system. It would effectively cause a collapse because no one would have the confidence to lend to a system that ignores its obligation to honor its debt. This will not be allowed to happen.
Another possibility is that FNM and FRE would be provided access to the Fed discount window. In other words, these corporations could obtain capital by putting up their mortgage paper to secure loans by the Fed. This would solve the problem if the bottom is close in housing prices. However, if housing prices were to continue to fall, this action would be like a bandaid on a severed limb. A total decline in house prices of 30% to 40% could require as much as $900 billion to $1.2 trillion in Fed financing. This is in excess of the money in circulation under the Fed. In order to provide liquidity, the Fed would need to have the Treasury issue more debt in order to obtain the necessary money to keep the Fed window open. Thus, the national debt would be increased. There would be some offsetting assets (value of mortgaged properties). The major problem, however, is capital, not liquidity. Therefore, this use of the Fed discount window would be outside the stated purpose of the facility.
Another possibility is the abolishment of FNM and FRE with the assets and liability assumed by the U.S. government. Instantaneously the national debt would be increased from the current value (approximately $3 trillion) to a new level of approximately $6 trillion. Unless our economy collapses, this increase in national debt is offset by approximately the same value in assets, the mortgaged properties. The problem is that, absent the huge mortgage financing vehicle represented by FNM and FRE, home mortgage financing would be reduced to a very low level. Absent the ability to obtain mortgages, buyers would not be able to buy homes. The housing market would dry up and home values could easily fall precipitously. In that event, the national debt would be permanently increased by the loss in home values. Therefore, if this option is pursued it would be necessary for the government to operate the mortgage underwriting business that FNM and FRE have operated in order to hold down the potential escalation of the national debt.
Inaction is not a possible solution. Some form of action will be taken by the government. The best result will have a mortgage market continue in the future. The best result will not be fractured if housing values drop another 20%. Preserving equity for FNM and FRE stockholders should not be a primary objective of the government action. It is most likely that government action will be to offer some form quarantee to FNM and FRE issued debt and to keep these corporate agencies operating, probably with more regulatory oversight.