United States: Fannie, Freddie

Monday, July 14

Treasury Secretary Henry Paulson yesterday outlined steps the federal government would take to shore-up the finances of government-sponsored mortgage enterprises Fannie Mae and Freddie Mac.  The administration felt compelled to act after the two institutions' stock prices plunged by half last week, due to the vital role Fannie and Freddie play in the US mortgage sector. Although both firms have enough capital, an increase in their cost of borrowing -- following a loss of market confidence -- could have transformed the housing sector correction into a historic rout.

Remedies

The administration will take two short-term steps designed to remove even the smallest possibility that the two ‘government-sponsored enterprises’ (GSEs) might face a liquidity crunch:

Paulson announced that henceforward Fannie and Freddie would be able to secure liquidity, if necessary, from the Federal Reserve's 'discount window' by posting their asset-backed securities as collateral.

The administration will ask Congress to increase the existing federal lines of credit offered to the two institutions -- allowing them potentially to secure cash even more cheaply than at the discount window.

The Treasury also indicated that it might seek "temporary" authority to buy equity directly in the GSEs -- part-nationalisation, in essence. It is unlikely to take this step in the near-term, which is simply designed to reassure markets that the government will not, under any circumstances, allow these entities to fail.

Responses

Paulson's intervention is likely to slow the sell-off in Fannie and Freddie stock, and bring down their borrowing costs somewhat. However, the market's worries about the GSEs could still have several negative economic effects:

• Further dollar weakness. Non-US investors have significant holdings of GSE debt (approximately 1 trillion dollars). The implicit government guarantee and the higher yield over US treasuries had made GSE debt attractive. If non-US investors divest themselves of GSE debt, this would place further downward pressure on an already weak dollar.
• International knock-on effects. For countries already experiencing tight and contracting mortgage markets, such as the United Kingdom and Ireland -- further turmoil in the US financial system and mortgage market may increase the already negative market sentiment in these places as well.
• Worsening US housing correction. As other lenders have pulled out of the mortgage market in the continuing housing crisis, Fannie and Freddie have taken up the slack and accounts for nearly three-quarters of new mortgages. If problems persist at the GSEs, other lenders may tighten lending even further. This would limit demand and thus place more downward pressure on house prices.

The administration's efforts to shore-up confidence in Fannie and Freddie will be successful in the near-term, alleviating the stock sell-off and reducing their cost of capital. However, Fannie and Freddie are likely to curtail their mortgage purchases, which will remove liquidity from the sector, boost the cost of mortgages, and deepen the housing market correction.