Government Steps in to Control Fannie and Freddie

The U.S. Treasury Department and the Federal Housing Finance Agency placed government sponsored entities Fannie Mae and Freddie Mac, which own or guarantee half of the country’s $12 trillion in outstanding home mortgage debt, into conservatorship Sunday, adding some stability to the troubled mortgage market.

The Treasury will own 7.9 percent of each GSE through new warrants, and will buy senior preferred stock as needed to maintain GAAP equity ratios. Lehman Brothers estimated that the warrants would reduce estimated year end 2008 core common book value per share from $19 to $4 per share at Fannie Mae and from $21 to $6 per share at Freddie Mac. Lehman predicted that Fannie and Freddie would return to profitability in 2010.

“I have long said that the housing correction poses the biggest risk to our econmy; it is a drag on our economic growth and at the heart of the turmoil and stress for our financial markets and financial institutions,” Treasury Secretary Henry M. Paulson said in a prepared statement. “Our economy and our markets will not recover until the bulk of the housing market is behind us. Therefore, the primary mission of these enterprises will now be to proactively work to increase the availability of mortgage finance, including by examining the guarantee fee structure with an eye toward mortgage affordability.”

To promote stability in the secondary mortgage market and to lower the cost of funding, the GSEs will modestly increase their portfolios of mortgage-backed securities through the end of 2009, Paulson said. Then, to address systematic risk, in 2010 their portfolios will be gradually be reduced at the rate of 10 percent per year, largely through natural run-off, eventually stabilizing at a lower, less risky size.

“At first blush, this seems like a positive thing for bondholders and has put equity holders in their place,” said John Jay, senior analyst for Aite Group.

A critical factor was that the GSEs had an implicit government guarantee for several years, but any definition of that guarantee was fuzzy at best, with debt holders, equity holders and internal managers all viewing it differently.

As a result, Jay doesn’t think that the government will be making implicit guarantees of financial entities or other companies any time soon.

“It got way out of hand,” Jay said.