San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The (Re)Nationalization of
Fannie Mae and Freddie Mac

In June of 2008 as Hank Paulson, the Secretary of the Treasury, was grappling with the problem of the possible financial collapse of Lehman Brothers he was confronted with another even bigger problem. The stock prices for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Company (Freddie Mac) were tumbling even worse than that of Lehman. To make matters worse Paulson's Deputy Secretary, Bob Steel, who had responsibility for monitoring Fannie and Freddie, was leaving to become the CEO of banking enterprise Wachovia.

Fannie Mae and Freddie Mac had initiated the subprime mortgage insanity in the 1990's by requiring lenders they dealth with as buyers of mortgage contracts to prove they were not redlining by fulfilling quotas of mortgages issued to minorities. To fulfill those quotas the lenders had to reduce the lending requirements on income, credit histories and down payments below what they had previously considered the minima acceptable. To fulfill the quotas Fannie and Freddie was have to issue what mortgages that were unsound. Fannie and Freddie eliminated the lenders' problem by being willing to buy or insure those subprime mortgages. Thus Fannie and Freddie, in effect, agreed to take the expected losses on the subprime mortgages. The market began demanding a higher interest rate on the subprime mortgages, as if a higher interest rate would turn them into better investments. The borrowers who were not good prospects for paying back the loan at the regular interest rate were even worse prospects for paying off a mortgage at the higher interest rate. However, the lenders no longer cared about the mortgage being paid back; the lenders would earn a substantial fee for writing the mortgage and then sell it to Fannie or Freddie. Since the fees for writing subprime mortgages were higher than for writing prime mortgages the lenders became aggressive in soliciting subprime borrowers.

The higher interest rates on subprime mortgages made them attractive for securitization. The higher risk was dealt with by pooling them and selling the rights to the payments accruing from the mortgages. One security would have first claim to the income generated by the mortgages and thus would be relatively risk-free. A second security would have second claim and so forth. The security last in line was in danger of not being paid. Such securities came to become known as toxic waste. Such securities were promised a high earnings rate, if paid.

The securitizers found that the amount that they could get for the securities based upon a mortgage pool was greater than the value of the mortgages in the pool. So, in effect, they could generate substantial profit through securitization. Fannie Mae and Freddie Mac, who at one time owned or insured 55 percent of the $1 trillion mortgage market, were in effect propping up the prime and subprime mortgage markets, saw the profit being made by the securitizers and began using there holdings of mortgages to issue such securities themselves. The profits Fannie and Freddie made on securitizations seemed to offset the losses that were developing as a result of their buying and their insuring of subprime mortgages. But the losses were not entirely offset and they were slowly erroding their capital base. Fannie and Freddie were among the largest enterprises in the world. Their policies with respect to subprime mortgages took ten years, from 1998 to 2008, to bankrupt them. In June of 2008 according to their official accounts they were not quite bankrupt but it was clear to the market that it was just a matter of time. Their stock prices were therefore falling rapidly.

Financial Characteristics of
Fannie Mae and Freddie Mac
as of 2007
CharacteristicFannie MaeFreddie Mac
Revenue$44.8 billion$43.1 billion
−5.1 billion−6.0 billion
Net Income−2.0 billion−3.1 billion
$882.5 billion$794.4 billion
Equity$44.0 billion$26.7 billion

The agency which regulated Fannie Mae and Freddie Mac was trying to present an entirely different picture. The chairman of the Federal Housing Enterprise Oversight said in July of 2008

Both of these companies are adequately capitalized. Both of these companies are managing through these issues and have tested management teams.

Not only did he say this, the agency formally certified that Fannie and Freddie had adequate capital.

Not many in responsible positions believed him but both enterprises had high ratings (AAA) on their financial obligations. That was soon to change. In August Moody's dropped the ratings on both companies preferred shares to less than investment grade, what is commonly referred to as junk.

Secretary Paulson became convinced that Fannie and Freddie could survive. He brought in Morgan Stanley to make a financial assessment. Morgan Stanley assigned forty of its staff to a three-week crash program of evaluation which enlisted thirteen hundred of Morgan Stanley's employees in India to review all of mortagages of the two companies. The conclusion of the assessment was that Fannie and Freddie needed $50 billion in cash. Furthermore foreign buyers of the securities of the two companies might well stop buying and start selling those securities.

Paulson concluded that he could not stabilize the financial markets and though them the economy without solving the problems of Fannie and Freddie. He rejected the option of letting the two companies go into bankruptcy. Instead he opted for what, in effect, was a takeover, a hostile takeover if necessary. This was at the end of August 2008. Paulson and his Treasury associates targeted the Labor Day weekend for the takeover. What they were planning was the takeover of two private companies whose regulatory authority had certified that they were financially sound. They would be replacing the top managers of the companies. Nevertheless they proceded to gain presidential approval for their objective.

On the afternoon of September 4, 2008 the chief executives of the two companies were called to meetings at the Federal Housing Finance Agency (FHFA). The meetings were with the Secretary of the Treasury (Paulson) and the Chairman of the Board of Governors of the Federal Reserve System (Bernanke). They were told that their companies were being taken over and that they would be replaced. The CEO of Freddie Mac acquiesed and informed his board of directors of what was taking place. The CEO tried to fight the takeover. When he tried to elicit help from allies in government he found that Paulson had already convinced them of the necessity of the action.

The board members of Fannie Mae were summoned for a meeting with Paulson and his group. They were told that the government would buy $1 billion of new shares of Fannie which would giver it 80 percent ownership of the company. In addition the government would provide new capital up to as much as $200 billion if necessary. Later that evening the board of Fannie Mae voted to accept the terms of Treasury's offer. It was an offer they could not refuse but also an offer that was guaranteeing the survival of their company.

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