RSSFannie/Freddie Crisis Threatens Construction Spending Forecast
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Reed Construction Data has lowered its forecast for housing, and somewhat less so for the rest of construction and the entire economy because of this risk to the prime mortgage market. The forecast will be posted shortly.
Fannie and Freddie hold only a few subprime loans forced on them by Congress so they largely escaped a direct hit from the write-down of these loans over the last year. Nonetheless, they managed to lose $11 billion over the last year. This was from the abrupt shrinking of the prime mortgage market, make-goods on the financial misbehavior both engaged in a few years ago and the higher borrowing costs as investors worldwide scrambled to get more capital.
Both are in a poor position to get the capital they need to cover write-downs on their assets caused by rising foreclosures on prime mortgages as a result of layoffs and plunging home prices. Apparently their shareholders suddenly realized that both Freddie and Fannie were too slow to write-down their assets and recognize their losses and that the implicit guarantee of their debt by the federal government could no longer be relied on. Their debts were too big.
This should not have happened. Several years ago their federal regulator, the Office of Federal housing enterprise Oversight (OFHEO), asked Congress to reduce their size and force them to raise more capital. But this was quickly shouted down by the housing industry that wanted to keep their guaranteed access to cheap capital.
Fannie and Freddie’s shareholders and bondholders may have panicked when they realized that Congress may quickly enact a mortgage regulation law that would permit Fannie and Freddie to expand further, require them to add capital and also require them to buy more high risk mortgages.
It is not clear how this mess will be resolved. The preferred approach in Washington, demonstrated in the recent Goldman Sachs failure and merger into Morgan Stanley, is to get investors to provide enough capital to the mortgage twins to get them out of technical default. This will be a tough sell to investors already struggling to find more capital for themselves.
At the other extreme, the shareholders get wiped out and the mortgage assets are put into receivership managed by OFHEO, which is part of Housing and Urban Development (HUD). The taxpayers then explicitly become the guarantors of Fannie and Freddie’s bonds. Surprise! We may all have HUD mortgages by Labor Day.
The Bush administration will try to avoid receivership because of the huge assumption of debt and HUD’s abysmal record of managing its own mortgages. But it could happen. There is a lot of support for federal receivership. It would bail out investors now at risk. A large share of the bonds are owned by conservative investors managing pension funds and foreign government exchange reserve funds who believed they always had a federal guarantee. Also, federal receivership opens the option for some in Congress to pressure regulators to forgive the debts of their constituents.
The final solution is most likely to be somewhere in the middle. Both bondholders and shareholders lose a little, big investors are strong-armed into contributing some capital and everyone pretends that this is enough because the problem is not really as bad as it seems.
Member Comments
Well put Jim. That is great analysis!
The uncontained failure of Fannie and Freddie would mean the effective end of home mortgage market and would do lots of harm to the global financial system.
A Conservatorship would keep Fannie and Freddie’s debt off the government books. If Fannie and Freddie had owed only 5 million instead of 5 trillion, they would have been allowed to fail just like Indymac. I just hope the Fed has a large enough broom to help sweep up this mess!
