GSE Chief Regulator: Fan and Fred vulnerable

May 18, 2008

This blog is dedicated to more than the deterioration of Fannie and Freddie, I promise. I think the reason I devote so much space to the topic is the sheer size of these two entities and the risk they pose to taxpayers.

Three facts to chew on:

  • At $5.3 trillion, the combined debt of Fannie and Freddie is half that of the entire Federal Government
  • “Core capital” at the two companies is less than 2% of that combined total of $5.3 trillion….less than $90 billion.
  • The companies’ exposure to subprime and Alt A mortgage loans (i.e. the most risky ones in the market), exceeded $700 billion at the end of last year.

A 20% fall in the value of their risky assets alone, would be enough to push them towards bankruptcy, forgetting for the moment that there may be billions of losses yet to take in their “prime” portfolios.

Fan and Fred function as financial guarantors on that $5.3 trillion debt. Losses are absorbed through a reduction in core capital. If losses are greater than core capital, the two companies are insolvent. Who pays the bill for any losses thereafter? Taxpayers.

And yet politicians and other housing industry professionals are leaning on Fan and Fred to take on more risk, to purchase more and sometimes riskier mortgages in an effort to funnel financing into the housing market to keep it from collapse (see previous post). Of course, the market is to big to be propped up artificially, so such efforts are just increasing the bill taxpayers will face when Fan/Fred end up in bankruptcy.

All of the above have been discussed at length on this blog. Why raise all of these facts again?

James Lockhart, head of the government agency that regulates Fan and Fred, is starting to speak in more ominous terms about his two charges:

“With that leverage, the enterprises could pose significant risk to taxpayers as well as to financial institutions and other investors that invest in and count on the liquidity of their debt and guaranteed” securities, Lockhart said.

Part of the problem, Lockhart said, is that the mortgage industry didn’t learn from past “blowups” and that regulators shouldn’t allow “overly liberal underwriting standards and mis- pricing of risks during a credit and asset boom.

“The build-up of risks makes it more likely that, during the inevitable correction, institutions will experience solvency problems and tighten underwriting standards more than warranted by credit considerations alone,” he said.

When someone as important as Lockhart starts talking about “solvency problems” and “inevitable corrections” it’s time to get scared.

It should be noted that Congress is considering housing legislation that, though primarily designed to bailout overstretched homeborrowers, may also contain provisions that strengthen regulation of Fan and Fred. Lockhart is hoping so. In particular, he wants the power to raise the capital requirements at both companies. The more capital they have on hand, the bigger the backstop against losses before taxpayers are forced to step in with a bailout.

Fan and Fred are resisting raising more capital because that dilutes the ownership stake of current shareholders.

On the one hand, the companies’ federal charter–i.e. the taxpayer guarantee of their debt–makes them beholden to the public. On the other hand, their quasi-private status as shareholder owned corporations makes them beholden to shareholders. They have an incentive to use debt guaranteed by the public to make money for shareholders. Most corporations have no such public guarantee. They are responsible for their own debts and as a result, most act more prudently.

Banks are forced to act more prudently. Their capital requirements are far higher than the 2% held in reserve by Fan and Fred…..

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