It's official! After a week in which Fannie Mae and Freddie Mac saw their stock prices slashed by nearly half, investors received confirmation of what they've always suspected: Uncle Sam will in fact step in if the congressionally chartered entities get in a serious jam. Looking to head off growing concerns that the mortgage finance giants might not have enough capital to weather the painful housing downturn, Treasury Secretary Henry Paulson on Sunday said he would take steps to temporarily increase Fannie and Freddie's credit lines with the department and even seek the authority to buy equity in either company should they need it. At the same time, the Fed voted to, in effect, provide Fannie and Freddie with access to its discount window.
The dramatic moves represent a sweeping effort to restore the market's confidence in Fannie and Freddie, which have become increasingly critical to the mortgage markets amid the ongoing housing crisis. Mike Larson, a real estate analyst at Weiss Research, says the government had little choice but to take such drastic action. "Fannie and Freddie have become sort of the last lifelines of liquidity for the mortgage market, and you can't have these huge gigantic institutions go under," Larson says. "Of the bad options out there, what [the federal government] is doing is probably the least bad of those options." So what does this all mean for investors and mortgage rates? U.S. News spoke with various industry professionals to find out.
The good news: Treasury is asking Congress to let it buy stock in the government-sponsored enterprises (GSEs) and raise the amount it can lend. Predictably, shares of Fannie and Freddie jumped between 20 and 30 percent in early trading. Unfortunately, the rally didn't last. The government's welcome show of support may stave off the worst-case scenario where the stocks go to zero, but both Fannie and Freddie were solidly in the red by midday.
That's because government support doesn't necessarily mean help for shareholders.
Paulson has reportedly made it clear he is willing to let shareholders take a bath rather than bail them out in order to avoid creating a "moral hazard." As the WSJ points out, bank bailouts during this crisis haven't exactly favored long-suffering equity investors. (Anybody own Bear Stearns shares?) Right now, the various scenarios for the future of Fannie and Freddie look like a choice between bad and worse for their stocks. First, the Fed's ability to buy up chunks of equity in the lenders could prove dilutive for shareholders. That's actually the good news. The opposite position—nationalization of the lenders—leaves investors in a scenario where shares basically become worthless. That is still a possibility.
Global Insight's Brian Bethune notes shares won't have much help until the Treasury telegraphs just how big an investment it's willing to make. He suggests the capital boost needs to be "very significant," possibly $20 billion or higher for both, in order to halt the sell-off.
Until that happens there is little for investors to do but watch and wait, a proposition that should grate on some nerves after watching shares plummet at least 75 percent this year in the wake of last week's massive drop.
If the GSEs' stockholders are sweating their shrinking portfolios, everyone should be worried about Fannie's and Freddie's debt.
The primary goal of the government's plan is to reinforce faith in the pair and stamp out the sort of crisis of confidence that results in failures like that of IndyMac over the weekend.
There are early signs the drastic weekend measures are working.
This morning, Freddie Mac started the week with a generally successful $3 billion auction of short-term debt. Positive demand for the offering, reportedly pushed over the weekend by Treasury officials in calls to investment banks, seems to have succeeded as modestly better-than-expected. Fannie Mae's treasurer told Reuters borrowing was "business as usual."
That's a ray of sunshine for debt holders. If investors back away from buying new debt, there's little the government or the GSEs can to do restore confidence in either company as a going concern. After the offering, prices for agency debt and mortgage-backed securities rose relative to treasuries.
"The concern was their ability to raise capital in the future. This suggests they'll have that ability to raise it without much trouble so I don't think it will weigh on debt holders tremendously," says Kim Rupert, managing director of global fixed income analysis at Action Economics.
In the end, a recovery in demand for agency debt might matter most for U.S. taxpayers who could be on the hook for some $5 billion in liabilities if the government actually assumes its now explicit guarantees for Fannie's and Freddie's loans. Guaranteeing those liabilities won't necessarily be costly since most will be backed by healthy mortgages. Still, adding $5.2 trillion worth of mortgages to the current $9 trillion U.S. deficit at a time when housing-related assets are still falling in price should be a big reason for everyone concerned to hope lenders can eventually stand on their own two feet. Keep an eye on Fannie Mae, which has an auction for short-term debt scheduled for Wednesday.
Current mortgage holders
If you already have a mortgage that is being held or guaranteed by Fannie and Freddie, the recent turmoil will not affect you, says Christopher Thornberg of Beacon Economics. "You are locked in ... the money is yours as long as you continue to pay [your mortgage]," Thornberg says. "That's not even an issue."
While the government's actions appear to have brought some short-term stability to the mortgage market, the long-term impact remains murky, Larson says. "Nobody really knows how much Fannie and Freddie are going to lose from the housing market," Larson says. "Until the housing market shows signs of a real turnaround, there is still the question of: Are we going to be in this same situation six months or 12 months down the road?" If investors conclude that the government's plan is not enough to resolve Fannie's and Freddie's capital concerns, they could demand higher returns on their mortgage-backed securities. Those higher costs will be passed along to consumers in the form of higher interest rates. "At the end of the day, there are only two people that pay—that's you and me," says Keith Gumbinger, vice president of HSH Associates.
Coupled with the growing inflationary pressures, the turmoil surrounding Fannie and Freddie represents another factor that could push mortgage interest rates modestly higher by the end of the year, Larson says. "I don't think we're going to see a huge increase, we're not going to 8 percent or anything," he says. "But I wouldn't be surprised to see six-and-three-quarters [or] seven percent on the 30-year fixed [rate mortgages]."
Coming Up Next
Vagaries of Paulson's plan leave room for uncertainty for investors of all sorts (not to mention that the plan hasn't yet been approved by Congress, though it appears set to pass). The next big moment in this drama comes tomorrow, when Fed Chairman Ben Bernanke offers his semiannual testimony before Congress. He'll undoubtedly address the bailout and its implications for the current pause in moving interest rates. Plus, it is earnings season, and this week is a big one for the financial sector where the pain being felt by Fannie and Freddie swept through shares like a brushfire earlier this year. Names to watch this week: Wells Fargo, JPMorgan Chase, Merrill Lynch, and Citigroup.