Money Matters - Simplified

Fannie and Freddie: 1 Year Later

This Monday, Sept. 7, is Labor Day. A day to celebrate. Relax. Forget about the hustle and bustle.

One thing we won't be celebrating is what went down exactly one year
prior: The collapse, and subsequent government takeover, of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

In the year since, Fannie and Freddie have received roughly $96
billion in taxpayer support, incrementally, to keep their net worths
above zero. Originally, a backstop of $200 billion was allocated to
keep the two afloat. That number was later bumped up to $400 billion.

While not solely, or even mostly, responsible for Wall Street's
collapse, this was really the first shot fired in what turned out to be
the fiercest financial panic in generations. Within days of the
mortgage giants' fall, Lehman Brothers went bust, Merrill Lynch fell
into Bank of America's (NYSE: BAC) arms, AIG (NYSE: AIG) imploded, money market funds froze, and the funding mechanism that financed Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) vanished. It turned real ugly, real quick. The beginning of the end, in a sense.

Danger from day 1

Markets, investors,
politicians, and homeowners knew all along that Fannie and Freddie were
backed by the full faith and credit of the government. This was not
your average bailout. Unquestioned government support was expected
long, long before markets began to unravel. However flawed this was, it
was their purpose: To have semi-private, semi-government, organizations
guaranteeing liquidity to the housing market, kept alive by taxpayers
at any cost.

It was that arrangement, though, that ultimately turned them into nuclear bombs. Back in 2004, fellow Fool Bill Mann wrote a fantastic article on how Fannie Mae operates, summing it up nicely:

Want to know why Fannie Mae is in trouble? It's
simple enough: This company, more than any other in America, is run by,
in the interests of, and with the protection from politicians, not
businesspeople.

Fannie and Freddie had two bosses to answer to: private
shareholders, and Congress. One side, theoretically, wanted calculated,
prudent risk. The other wanted to make people happy, put everyone in a
home, and get reelected. The chasm between the two interests is so vast
that, in hindsight, ever assuming the outcome would be anything but
terrible was truly unrealistic.

What now?

What happened last year happened last year. The question now should be what to do with what's left of Fannie and Freddie.

In a press release last September, then-Treasury Secretary Hank
Paulson said, "Fannie Mae and Freddie Mac are so large and so
interwoven in our financial system that a failure of either of them
would cause great turmoil in our financial markets here at home and
around the globe."

All well and true. But it raises the question: What's changed since then? Are the two now less prone to blowing things up?

With a bottomless backstop, I suppose they are. But what's really
changed in the past year is that the two now only have to answer to one
master: Uncle Sam. Consequently, risk restrictions on refinanceable
loans have been relaxed twice, first from LTV ratios north of 80%, then recently to 125%. Fannie Mae admits
it isn't in the business of making profit anymore. Both can keep
capital levels at or near insolvency, knowing more capital will be
provided as needed.

Who accepts Fannie and Freddie's risk has indeed changed, but the amount of risk at hand has not.

I don't doubt that putting the two into conservatorship was the right thing to do. As Berkshire Hathaway (NYSE: BRK-B)
co-chairman Charlie Munger noted, "Nationalizing Fannie Mae and Freddie
Mac and promptly allowing all the sound loans in the country to be
redone at low interest rates was a marvelous idea."

What's questionable is the path the two are currently on,
post-nationalization: They have been effectively stripped of their
duties to shareholders, now only obligated to serve a group whose
priorities may wander away from what's beneficial in the long term, to
put it politely. If you've ever watched the House Financial Services
Committee debate, you know what I'm talking about. This isn't a group
even vaguely qualified to run what's essentially a blind, drunk,
multitrillion-dollar hedge fund.

You take it from here

At any rate, I
want to know what you think. What should happen to Fannie and Freddie?
Break 'em up? Nurse 'em back to health? Kill the two once and for all?
Hit the reset button and start again? Feel free to share your thoughts
in the comment section below.

 

Copyright 2009 by United Press International.