The Biggest Bailout In History!

The US has taken its two biggest mortgage lenders, Fannie Mae and Freddie Mac, into public ownership. Think of it as 33 Northern Rock rescues at once.

Stock markets across the globe reacted with relief today on the news that the US government is to take control of two giant mortgage lenders, Fannie Mae and Freddie Mac. The troubled firms -- which together own or guarantee $5.4 trillion of American mortgages -- are being taken public in order to restore confidence in their ability to continue as ongoing concerns.

Too big to fail

To put this mind-boggling figure into context, $5.4 trillion is £3,056 billion, or more than twice our gross domestic product (GDP, the UK's total income and output) of £1,410 billion. Hence, you have to admire the Yanks, because when they do something, they do it big!

As financial news goes, it doesn't get much spectacular than this. Total US mortgage lending is $12 trillion; almost half of this sum is owned or guaranteed by Fannie and Freddie. What's more, the two firms guarantee almost four-fifths (80%) of new home loans, placing them at the centre of the US housing market. Thus, with immediate effect, the firms are to enter `conservatorship' under the care of housing regulator the Federal Housing Finance Agency.

What are Fannie Mae and Freddie Mac?

The Federal National Mortgage Association (FNMA, or Fannie Mae) was created under President Roosevelt in 1938 in order to lower home-owning costs by providing funds and liquidity to the US mortgage market. In 1968, Fannie became a shareholder-owned company listed on the New York Stock Exchange, but continued to enjoy implied financial support from the US government.

Likewise, the Federal Home Loan Mortgage Corporation (Freddie Mac) was created in 1970 in order to increase the size and liquidity of the secondary market for mortgages. Again, this made it easier for lenders to package up and sell on parcels of home loans, keeping costs down for homeowners.

However, Fannie and Freddie do not lend direct to borrowers; instead, they buy thirty-year home loans from US mortgage lenders and sell these on to investors in the form of bonds (company IOUs). Almost every US mortgage lender, from the biggest to the smallest, relies on the firms to take mortgages off their hands, allowing them to lend even more to borrowers.

What went wrong?

Thus, as `government-sponsored enterprises', Fannie and Freddie were able to raise funds cheaply by issuing bonds to investors at yields not much higher than those issued by the US Treasury itself. A large proportion of these bonds are owned by other banks and governments around the world, putting Fannie and Freddie at the heart of a spider's web of financial problems across the globe.

Alas, thanks to falling property prices, Fannie and Freddie have racked up huge losses. With US property prices down around 15% in the past year, and one in eleven (9% of) American homeowners in arrears with mortgage repayments, the firms have lost nearly $15 billion in the past year. This led the firms' share prices to collapse -- they have plunged around 98% in the past twelve months.

Although the US Treasury has described its action as `conservatorship', this is just spin for `nationalisation'. Indeed, there is some parallel with failed bank Northern Rock, although Freddie and Fannie's lending is 33 times the £90 billion mortgage book taken on by HM Treasury.

The US government could be forced to stump up between $25 billion and $200 billion in capital injections to support the two nationalised firms. However, had these companies failed, the knock-on effects around the world would have been devastating, possibly leading to even greater losses for US taxpayers. This puts our home-grown Northern Rock crisis in the shade!

Good news for some, bad for others...

Fannie and Freddie are now on a firmer footing. Of course, today's bailout is aimed at propping up the ailing US property market, which is good news for struggling US homeowners as home loans become cheaper.

Thus, US lenders will breathe a sigh of relief that liquidity is set to improve and the GSE bonds they own will no longer continue to decline in value. Elsewhere, stock markets responded with a relief rally, rising by around 4% in Europe and the Far East.

On the other hand, shareholders in the two firms are all but wiped out. When Wall Street opened earlier, their shares crashed by four-fifths (80%), taking them to just over a dollar apiece, down from $70 or so last year. Equally, the management teams will be looking for work as the government replaces its key staff.

What about this side of the Atlantic?

The main benefit of this move will be the removal of a major blockage in the US mortgage market, providing much-needed relief to banks and lower interest rates to buyers. This should help the US housing market to recover earlier and dive less steeply than it would otherwise have done.

After a steady stream of bad news for the housing market, this could mark the beginning of the turnaround for the US. However, there is still a fundamental weakness in that market, caused by a huge over-supply of homes for sale. Hence, it could be well into 2009 or 2010 before the sun starts shining on sellers once more.

On this side of the Big Pond, we have our own little mortgage crisis, leading to the rescue of two small lenders today, as I reported in Nationwide Takes Over Cheshire And Derbyshire. As far as the UK housing market goes, this news is probably of more significance than the nationalisation of Fannie and Freddie.

Nevertheless, British banks will be relieved that they won't have to write off large sums from losses on GSE-issued bonds. After the catastrophe at Northern Rock, the near-failure of Bradford & Bingley, the proposed takeover of Alliance & Leicester by Spanish bank Santander, and rescue rights issues by leading lenders Barclays, HBOS and RBS, the last thing we need is more bad news from British banks!

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