Federal takeover of Fannie Mae and Freddie Mac

Overview

In September 2008, the Federal Housing Finance Agency (FHFA) announced that it would take over the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both government-sponsored enterprises, which finance home mortgages in the United States by issuing bonds, had become illiquid as the market for those bonds collapsed in the subprime mortgage crisis. The FHFA established conservatorships in which each enterprise's management works under the FHFA's direction to reduce losses and to develop a new operating structure that will allow a return to self-management. As of 2024, Fannie Mae and Freddie Mac remain under conservatorship, and after more than repaying their Treasury loans are building capital reserves for an expected eventual exit.

Background and financial market crisis

The combined GSE losses of US$14.9 billion and market concerns about their ability to raise capital and debt threatened to disrupt the U.S. housing financial market. The Treasury committed to investing as much as US$200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating. The two GSEs had outstanding more than US$5 trillion in mortgage-backed securities (MBS) and debt; the debt portion alone was $1.6 trillion. The conservatorship action has been described as "one of the most sweeping government interventions in private financial markets in decades" and one that "could turn into the biggest and costliest government bailout ever of private companies". With a growing sense of crisis in U.S. financial markets, the conservatorship action and commitment by the U.S. government to backstop the two GSEs with up to US$200 billion in additional capital turned out to be the first significant event in a tumultuous month among U.S.-based investment banking, financial institutions, and federal regulatory bodies. By September 15, 2008, the 158-year-old Lehman Brothers holding company filed for bankruptcy with the intent to liquidate its assets, leaving its financially sound subsidiaries operational and outside of the bankruptcy filing. The collapse was the largest investment bank failure since Drexel Burnham Lambert in 1990. The 94-year-old Merrill Lynch accepted a purchase offer by Bank of America for approximately US$50 billion, a big drop from a year-earlier market valuation of about US$100 billion. A credit rating downgrade of the large insurer American International Group (AIG) led to a September 16, 2008 rescue agreement with the Federal Reserve Bank for a US$85 billion secured loan facility, in exchange for warrants for 79.9% of the equity of AIG.

Previous attempts at GSE reform

In 2003, the Bush Administration sought to create a new agency, replacing the Office of Federal Housing Enterprise Oversight, to oversee Fannie Mae and Freddie Mac. In 1992, in the wake of the savings and loan crisis, and over concern that similar lending problems would develop, the Office of Federal Housing Enterprise Oversight was created as part of the Department of Housing and Urban Development. While Senate and House leaders voiced their intention to bring about the needed legislation, no reform bills materialized. A Senate reform bill introduced by Senator Jon Corzine (D-NJ) (S.1656) never made it out of the 21-member (10 D, 11 R) Senate Banking, Housing, and Urban Affairs Committee. At the time, some members of the 108th Congress expressed faith in the solvency of Fannie Mae and Freddie Mac. Congressman Barney Frank (D-MA), for example, described them as "not facing any kind of financial crisis". In 2005, the Federal Housing Enterprise Regulatory Reform Act, sponsored by Senator Chuck Hagel (R-NE) and co-sponsored by Senators Elizabeth Dole (R-NC), John McCain (R-AZ) and John Sununu (R-NH), would have increased government oversight of loans given by Fannie Mae and Freddie Mac. Like the 2003 bill, it also died in the Senate Banking, Housing, and Urban Affairs Committee, this time in the 109th Congress. A full and accurate record of the congressional attempts to regulate the housing GSEs is given in the Congressional Record prepared in 2005.

Federal Housing Finance Agency and Treasury authority

The Housing and Economic Recovery Act of 2008—passed by the United States Congress on July 24, 2008, with bipartisan support and signed into law by President George W. Bush on July 30, 2008—enabled expanded regulatory authority over Fannie Mae and Freddie Mac by the newly established FHFA, and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac, limited only by the amount of debt that the entire federal government is permitted by law to commit to. The law raised the Treasury's debt ceiling by US$800 billion, to a total of US$10.7 trillion, in anticipation of the potential need for the Treasury to have the flexibility to support Fannie Mae, Freddie Mac, or the Federal Home Loan Banks.

Prior GSE support measures

The September 7 conservatorship was termed by The Economist as the "second" bailout of the GSEs. Prior to the enactment of the Housing and Economic Recovery Act of 2008, on July 13, 2008, Treasury Secretary Henry Paulson announced an effort to backstop the GSEs based on prior statutory authority, in coordination with the Federal Reserve Bank. That announcement occurred after a week in which the market values of shares of Fannie Mae and Freddie Mac fell almost by half (from a previously diminished value of approximately half of year-earlier market highs). That plan contained three measures: an increase in the line of credit available to the GSEs from the Treasury to provide liquidity; the right for the Treasury to purchase equity in the GSEs, to provide capital; and a consultative role for the Federal Reserve in a reformed GSE regulatory system. On the same day, the Federal Reserve announced that the Federal Reserve Bank of New York would have the right to lend to the GSEs as necessary.

Capital infusion by the Treasury

The agreement the Treasury made with both GSEs specifies that in exchange for future support and capital investments of up to US$100 billion in each GSE, at the inception of the conservatorship, each GSE shall issue to the Treasury US$1 billion of senior preferred stock, with a 10% coupon, without cost to the Treasury. Also, each GSE contracted to issue common stock warrants representing an ownership stake of 79.9%, at an exercise price of one-thousandth of a U.S. cent ($0.00001) per share, and with a warrant duration of twenty years. The conservator, FHFA, signed the agreements on behalf of the GSEs. The $100 billion amount for each GSE was chosen to indicate the level of commitment that the U.S. Treasury is willing to make to keep the financial operations and financial conditions solvent and sustainable for both GSEs. The agreements were designed to protect the senior and subordinate debt and the mortgage-backed securities of the GSEs. The GSEs' common stock and existing preferred shareholders will bear any losses ahead of the government. Among other conditions of the agreement, each GSE's retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion.

FHFA initial actions as conservator

In the September 6, 2008 conservatorship announcement, Lockhart indicated the following items in the plan of action for the Federal Housing Finance Agency conservatorship:

On September 8, 2008, the first business day of the conservatorship, business will be transacted normally, with stronger backing for the holders of mortgage-backed securities (MBS), senior debt and subordinated debt. The Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month, without capital constraints. As the conservator, the FHFA will assume the power of the Board and management. The present Chief Executive Officers (CEOs) of both Fannie Mae and Freddie Mac have been dismissed but will stay on to help with the transition. Appointed as CEOs are Herbert M. Allison for Fannie Mae and David M. Moffett for Freddie Mac. Allison is a former vice chairman of Merrill Lynch and, for the last eight years, chairman of TIAA-CREF. Moffett is the former vice chairman and CFO of US Bancorp. Their compensation will be significantly lower than the outgoing CEOs. They will be joined by equally strong non-executive chairmen. Other management actions will be very limited. The new CEOs agreed it was important to work with the current management teams and employees to encourage them to stay and to continue to make important improvements to the Enterprises. To conserve over $2 billion annually in capital, the common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will remain outstanding. Subordinated debt interest and principal payments will continue to be made. All political activities, including all lobbying, will be halted immediately. Charitable activities will be reviewed. There will be a financing and investment relationship with the U.S. Treasury via three different financing facilities to provide critically needed support to Freddie Mac and Fannie Mae and also to the liquidity of the mortgage market. One of the three facilities is a secured liquidity facility, which will be not only for Fannie Mae and Freddie Mac, but also for the 12 Federal Home Loan Banks that are regulated by FHFA.

Government support for Fannie Mae and Freddie Mac

In addition to the government conservatorship, which CBO estimates will increase the federal government's net liabilities by $238 billion, several government agencies have taken steps to increase liquidity within Fannie Mae and Freddie Mac. Among these steps includes:

Federal Reserve purchases of $23 billion in GSE debt (out of a potential $100 billion) and $53 billion in GSE-held mortgage backed securities (out of a potential $500 billion). The Federal Reserve purchases of $24 billion in GSE debt. Treasury Department purchases of $14 billion in GSE stock (out of a potential $200 billion). Treasury Department purchases of $71 billion in mortgage backed securities Federal Reserve extension of primary credit rate for loans to the GSEs

National debt accounting

The on- or off-balance sheet obligations of the two GSEs, which are "independent" corporations rather than federal agencies, are just over $5 trillion, a significant amount when compared to the $9.5 trillion of officially reported United States public debt at the time of the takeover. The September 6, 2008 conservatorship and the subsequent planned Treasury infusion of capital support the senior liabilities, subordinated indebtedness, and mortgage guarantees of the two firms. Some observers see this as an effective nationalization of the companies that ultimately places taxpayers at risk for all their liabilities. The federal government follows specialized accounting standards set by the Federal Accounting Standards Advisory Board. The net exposure to taxpayers is difficult to determine at the time of the takeover and depends on several factors, such as declines in housing prices and losses on mortgage assets in the future. The Congressional Budget Office director, Peter R. Orszag announced on September 9, 2008, that the CBO intended to incorporate the assets and liabilities of the two companies into their federal budget planning due to the degree of government control over the entities. On September 12, 2008, White House Budget Director Jim Nussle indicated their budget plans would not incorporate the GSE debt into the budget because of the temporary nature of the conservator intervention. Bloomberg reported that according to CMA Datavision of London, "five-year credit-default swap contracts on U.S. government debt increased 3.5 basis points on September 9, 2008 to a record 18, up from 6 basis points in April," in reaction to concerns about the potential rise in U.S. debt from bailouts.

Related legislation

On May 8, 2013, Representatives Scott Garrett introduced the Budget and Accounting Transparency Act of 2014 (H.R. 1872; 113th Congress) into the United States House of Representatives during the 113th United States Congress. The bill, if it were passed, would modify the budgetary treatment of federal credit programs, such as Fannie Mae and Freddie Mac. The bill would require that the cost of direct loans or loan guarantees be recognized in the federal budget on a fair-value basis using guidelines set forth by the Financial Accounting Standards Board. The changes made by the bill would mean that Fannie Mae and Freddie Mac were counted on the budget instead of considered separately and would mean that the debt of those two programs would be included in the national debt. These programs themselves would not be changed, but how they are accounted for in the United States federal budget would be. The goal of the bill is to improve the accuracy of how some programs are accounted for in the federal budget.

Bank reserves

Many commercial banks in the United States own Freddie and Fannie preferred shares. Those shares have had their dividends suspended and are junior to the senior preferred stock issued to the Treasury in the restructuring of the two companies. The market value of the preferred shares plunged after the restructuring announcement and suspension of dividends. Banks were required to write down the value of Freddie and Fannie preferred stock held in their portfolios, compounding capitalization concerns for certain U.S. banks. Gateway bank agreed to be bought out by Hampton Roads Bankshares Inc. to make up for a writedown of $40 million on its stock in Fannie and Freddie, which put it below regulatory requirements to be considered adequately capitalized.

Credit default swaps

In the credit default swap (CDS) market, the standard contracts typically used between parties to a swap define the action of placing Fannie Mae and Freddie Mac into conservatorship as equivalent to bankruptcy, because of the change in management control. In CDS parlance, this is termed a credit event, and that triggers the settling of outstanding contracts for the derivatives, which are used to hedge or speculate on the potential risk that a company will default on its bonds. The two GSEs have approximately US$1.5 trillion in bonds outstanding, and since the market for credit default swaps is not public, there is no central reporting mechanism to verify how many credit default swaps are linked to those bonds. One estimate floated is US$500 billion, and the entire CDS market has a nominal value in the vicinity of US$62 trillion. Settlement on the contracts will likely be the largest in the market's decade-long history. Credit-default swaps on Fannie and Freddie have been among the most actively traded in the several months leading up to the conservatorship. "Thirteen'major' dealers of credit-default swaps agreed 'unanimously' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds," according to a memo circulated by the International Swaps and Derivatives Association (ISDA) after the conservatorship announcement. The day after the conservatorship announcement, the International Swaps and Derivatives Association, which sets industry standardized contracts for financial derivatives and swaps, announced it was working on a protocol on how to evaluate and settle Fannie Mae and Freddie Mac credit default swaps. Most of these swaps were settled on October 6, 2008. Paradoxically (in relation to typical experiences when a company issuing bonds has a "credit event"), the value of the two GSE bonds rose to the vicinity of par value after the conservatorship. This means that some owners of swaps that were hedging against the risk of a bond default may be worse off, since the value of the bonds may be higher than when they purchased the swap. Cash auctions were reported to be scheduled for October 2008 to settle CDS contracts in relation to the GSEs.