Misgiving #9 - U.S. Government Seizes Control of Nation's Two Largest Banks, FNMA and FHMLC

This morning the United States Treasury Department announced the Federal takeover of mortgage giants Fannie Mae and Freddie Mac. Department Secretary Henry Paulson made the declaration in the midst of significant uncertaintly on Wall Street regarding the solvency of the two banks to survive losses in excess of $3 billion resulting from defaulting loans.

Henry Allison and David Moffett were the CEO's of Fannie Mae and Freddie Mac, respectively. The Chief Executive Officers of both companies have been ousted and all portfolio loans under both agencies will be managed by the Federal Housing Finance Agency. Freddie Mac and Fannie Mae together control or insure over half of the nation's $12 trillion mortgage market.

With combined revenues of $84 billion and assets, they have lost more than $10 billion and sent major concerns through not only the secondary mortgage market, but now the public securities market as well.

Many Democrats adamantly support the Bush Administration's move, but the political fallout has yet to be seen as the government initiates one of the most significant takeovers in decades. As Government Sponsored Entities, the two corporations are private but loosely regulated by the Department of Housing and Urban Development and the Office of Federal Housing Enterprise Oversight. However, this move will amount to a Federal buyout of investors and potentially billions in taxpayer dollars being needed to shore up the corporations in light of defaulting mortgages.

Fannie Mae was created in 1938 by the Roosevelt administration to help assure liquidity in the private and government-backed mortgage market for the sake of private banking institutions. It became a private corporation in 1968, and became a guarantor of private and commercial loans only, with government loans falling under the control of another new Federal agency, the Government National Mortgage Association. (Ginnie Mae)

When Fannie Mae was made private in 1968, the Congress realized that there needed to be a balance of corporate competition, and in 1970 they chartered the creation of the Federal Home Loan Mortgage Corporation (Freddie Mac for short), providing the services of bundling mortgages into securities to be sold as a package on the investment market.

It was the development in the 70's of the speculating market in mortgage securities that led to Fannie Mae and Freddie Mac finding themselves at the helm of nearly the entire U.S. mortgage market, yet under the whim of the stock market and it's idiosyncrasies.

The most recent credit crisis was initiated by many factors, but most significant of which was the insertion of loans issued under bad credit (sub prime, high-interest government loans and other riskier loans) into the same consolidated mortgage investment instruments as those with low-risk loans, then giving them the same investment rating as the higher value securities. Fannie Mae, Freddie Mac as well as other large commercial banks bought and sold these instruments on the secondary mortgage market throughout the housing boom of the last decade without concern to the bad loans sitting within the securities they had built their equity upon. When the cards began to fall in 2004, some thought nothing of the ripples made by a temporary disruption in one or two banks that had failed to balance their sheets or invest wisely. However, when larger mortgage companies began revealing mounting foreclosures and losses, Wall Street began to take notice.

The housing market had exploded with a vengeance for over 5 years, and as home prices began to stabilize the sub prime and adjustable-rate mortgages that had become so prevalent began to weigh on the banks that had bought securities with these loans consolidated into them. As homeowners found themselves unable to refinance out of these loans because of a flat real estate market, foreclosures began to rise with an equal vengeance, causing a flat market to begin to pull backward. With foreclosures doubling and housing values (the last source of stability in a failed loan package) falling like a rock, many banks began to fail, or merge with other banks to cover their losses. Traditional banks and investment houses who had gambled on the rising real estate market suffered mightily in the mounting crisis, and the downturn claimed the lives of banks such as Countrywide, Merrill Lynch and event the stalwart Bear Stearns.

Understandably, the Federal Government feels an impulse to aid failing homeowners and inject some confidence into the market, but after hundreds of billions of dollars have been borrowed to shore up the industry the Treasury Department now sees it as necessary to take over the two largest corporations in the mortgage world, shielding investors from the consequences of a capitalist system that routinely corrects itself as necessary when the excesses of failed judgment come back to haunt those who looked idly by, including the Federal Reserve.

The Government does bear responsibility for some of this mess, but I believe the best course would have been better oversight (NOT meaning "regulation"), and the best course now is to allow the market to correct itself, which it is already doing. Banks fail when investors make mistakes in judgment, but the system fails when the government steps in to stop the necessary bleeding that allows the whole of the market to prosper over time. The stock of these two companies has fallen nearly 90% from their one-year highs, as of July of this year. However, as in every free market recovery, this only presents a lesson in discretion to those that lose, and an opportunity for reward for those who buy these devalued shares now.

Democrat Party nominee Barack Obama spoke at a campaign stop in Indiana and addressed his concerns about the takeover plan, but refused to pass judgment until he sees the Bush Administration's plan. Meanwhile, Republican candidates John McCain and Sarah Palin were campaigning in Colorado Springs, CO and gave their take on the financial crisis and pending takeover. McCain said this is another clear example of the nation's economic woes, and lemented that "Today, we're looking at another federal bailout of our home loan agencies".

Vice Presidential candidate Sarah Palin responded by saying, “They’ve gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help.”

I am adamantly opposed to this "bailout" of Fannie Mae and Freddie Mac, and support the full disclosure of the manner in which these entities run their books. In addition, I believe future oversight can be accomplished by tightly regulating the manner in which mortgage securities are bundled together and graded, but much else would be a violation of our free market principles and would reward only those investors who made foolish decisions to begin with and deserve to suffer the consequences of their failure in prudence.