Fannie Mae and Freddie Mac: Too Fat to Fail

Fannie Mae and Freddie Mac sound like an aging aunt and uncle, but the news that they've run into trouble is rather more daunting than any family problem. In fact, the behavior of this errant pair will have consequences for pretty nearly every family in the country.

They are of course two gigantic government-sponsored enterprises that rank among our 10 largest financial institutions. These days, they provide over three quarters of all home mortgages and cumulatively hold about $5.5 trillion in mortgages and mortgage guarantees. They were set up to expand homeownership by buying mortgages from private lenders, allowing more mortgages to be made.

Subsequently, they became public companies, and their management ran them as such. But because they were created by Congress, bond investors came to believe that Congress would always honor the debt they'd issued. This implicit government guarantee means they've been able to borrow money for less even than AAA rates—despite the fact that their balance sheets would justify a much lower credit rating and thus higher interest charges. The relatively lower cost of their debt is passed through to borrowers in the form of lower interest rates. But about one third of that credit advantage, or about $10 billion a year, is retained for the benefit of the companies' stockholders.

Fannie and Freddie have an equity cushion of slightly over $80 billion. It sounds like a lot, but not when compared with the roughly $5.5 trillion of mortgages they either own or guarantee. Even a small decline—say, 2 percent—of the value of those assets would be $110 billion and would wipe out the equity.

Excess leverage. Yet that is the risk today. Their loans are better than the subprimes that have triggered the crisis; the F&F guidelines require substantial down payments and carefully documented borrower income statements. It's their balance sheet that's the problem. The belief that the government would implicitly back their bonds enabled them to get by with too little equity capital to deal with a downturn. Now, a further loss of confidence in either Fannie or Freddie—that is, a belief that the government wouldn't back them—would collapse their creditworthiness. Neither would be able to come up with anything like their current share of U.S. mortgages. Anybody with a room-temperature financial IQ knows these companies would be unable to raise the capital they need, either to cover their losses or to rebuild. Indeed, under all scenarios, there is a risk that they will be unable to roll over even the $463 billion of short-term debt they have on their books.

You need little imagination to see what this would do to house prices, families—and lenders: Many banks have balance sheets stuffed with Fannie and Freddie mortgages, sometimes exceeding their net worth. They wouldn't be able to withstand such losses.

An actual failure of F&F would force the government to nationalize them, making explicit what has long been implicit. But this would add more than $5 trillion of liabilities to America's own balance sheet, which would put our own AAA rating at risk or, as Financial Times guru Martin Wolf described it, "make the U.S. look like Italy."A collapse of Fannie and Freddie is unthinkable because it would provoke a systemic risk to the financial world. Too many firms across America, and the world, are holders of their securities. And since F&F are these days virtually the only consistent buyers and securitizers of U.S. home mortgages, a decline in their lending could bring housing finance to a virtual standstill.

Nobody knows where the vicious downward spiral gripping our housing market will end or how far the assets of F&F will have to be written down. Home foreclosures continue to drive down prices because banks cannot afford to hold on to vacant homes and fear prices will keep falling.

The predicaments have long been predicted. F&F, along with Wall Street and home builders, staved off proper regulations by hiring political elites and lobbyists from both parties. They should have raised more equity but preferred higher profits per share. Their senior officers have made millions of dollars from their shareholdings. They are the winners. Now the losers will be we, the taxpayers, because F&F are too big to fail. The bailout legislation provides for more oversight, but it must be through a regulator with real teeth. It would be unconscionable for Congress to bail them out without making sure that this dangerous aunt and uncle will hereafter be restrained for the public good.