There has certainly been a lot of action in the stock market over the
last year. The S&P 500 is off over 25% since the highs in
October. The nation's two largest banks, Bank of America and
Citigroup, have both lost over 60% in the last year, and the nation's
backbones of the mortgage market and real estate sector, Fannie Mae, and
Freddie Mac are both down over 90%. With investor's speculating that
Fannie Mae and Freddie Mac are undercapitalized and could both go
bankrupt, how does this affect you?
Last month, Secretary of the Treasury Hank Paulson released a plan to save
Fannie and Freddie, or the government sponsored entities (GSEs). He
released a three-prong plan:
1) As a liquidity backstop, the plan includes an 18-month temporary
increase in Treasury’s existing authority to make credit available for
the GSEs.
2) To ensure the GSEs have access to sufficient capital to continue to
fulfill their mission, the plan gives Treasury an 18-month temporary
authority to purchase – only if necessary – equity(shares in the stock
market) in either of the two GSEs.
3) To help protect the financial system from future systemic risk, the
plan adds further regulatory reform by providing the Federal Reserve
authority to access information and perform a consultative role as a
regulator for setting capital requirements and other prudent standards.
What does this plan mean for Fannie and Freddie?
Many analysts believe this move by the Federal government will save the
GSEs from going bankrupt. The debt of Fannie Mae and Freddie Mae are
held by institutions and governments all over the world. For these
institutions to go bankrupt would be extremely devastating to the world
economy and to the reputation of the United States. Although the
institutions won't go bankrupt, the stocks of the two GSEs could
eventually be left worthless in attempts to save them.
An interesting facet of this plan is that Treasury Secretary Hank Paulson
is asking Congress for an unlimited credit line the Treasury can extend to
the GSEs. This has brought opposition to the plan from both
Democrats and Republicans. Many Congressman fear this unlimited
credit line could put taxpayers on the line for billions. Paulson
believes if an amount is specified, then investors will bet against the
GSEs and force the government to use that money. Paulson made the
analogy: If you carry a water pistol, you are going to have to use it.
If you carry a bazooka, chances are you won't be challenged and
forced to use it.
While Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben
Bernanke believe the GSEs are well-capitalized and will survive, the fact
is that if the government takes over the GSEs and then disbands them,
there can be significant long-term effects.
What does this mean for you?
If the GSEs are bailed out, chances are they could be permanently
disbanded. Many people in government don’t like these quasi-public
entities that are private in good times and are public in bad times
forcing the government to dole out billions. While Fannie Mae and
Freddie Mac state they don't need to raise money, the concern that they
are under-capitalized is very real. With the prospect of bankruptcy,
it may be very hard to raise more money. In a world where Fannie and
Freddie are destroyed, mortgage rates will go up about 1-2% from what is
currently offered. In the short-term, the higher mortgage rates may
lead to more foreclosures. In the long-term, higher mortgage rates
make it harder and more expensive to become a homeowner. Moreover,
many banks hold securities that are linked to Fannie Mae and Freddie Mac.
The downfall of these institutions could lead to more bank failures.
While there may come a day where Freddie Mae and Fannie Mac no longer
exist, you should be prepared for the consequences that ensue. Fannie
and Freddie are crucial to the structure of the financial system and real
estate markets, and it will cost you real money if they are not in place.
