The giant mortgage lenders Fannie Mae and Freddie Mac, seized and salvaged by the government at the peak of the financial crisis, have become the fiscal equivalent of unwelcome house guests for the Obama administration.
The Treasury took on their debts and spent more than $100 billion in 2009 to keep the two formerly private mortgage behemoths afloat. That intervention was critical: The two lenders guarantee or own half of the country’s total mortgages—more than $5 trillion worth—and were deemed by the Bush administration to be too big to fail. Now that the crisis is past, however, President Obama and his advisers would like to send Fannie and Freddie packing.
But the administration is facing a dilemma as it seeks to return the two companies to financial health, either as private or government entities. The government has guaranteed their investments, but their debt is not officially on the U.S. books—a budgetary maneuver that some say enables the administration to understate the public debt, now at $12.5 trillion, by $1.6 trillion. Cut loose from government backing, Fannie and Freddie could quickly become insolvent again, perhaps dragging down the unstable housing market with them. On the other hand, officially shouldering the losses that would render them healthy could force the administration to add all those bad mortgages to the U.S. debt.
With the economy still rocky and other issues on its agenda, the administration doesn't want to confront the Fannie and Freddie issue now. But influential voices across Washington, including Federal Reserve Chairman Ben Bernanke and House Financial Services Committee Chairman Barney Frank, D-Mass., who spooked investors last week with a warning that investments in Fannie and Freddie might be less than safe, increasingly say that this situation cannot hold much longer.
"I think, for no other reason than just trying to reduce uncertainty in the markets, the sooner that you can come to some clarity on the future of Fannie and Freddie, the better," Bernanke told the Senate Banking Committee on Feb. 25.
The Treasury's response is to delay a full plan until 2011, when it hopes some certainty has returned to the economy and the administration can safely set about creating a new, post-recession government structure for the housing market. At that point, officials would decide not just the fate of Fannie and Freddie but the overall role the government would play in the market and in encouraging homeownership—decisions with major implications for mortgage rates and housing prices.
“If we’re going to get this right, we want to make sure that we are proposing these changes at a time when we have a little more distance from the worst housing crisis in generations," Treasury Secretary Tim Geithner told the House Budget Committee last month. "We want to make sure that we get it right, that we do it carefully. We can't do everything right away,"
Fannie and Freddie were private companies created by Congress that used investors' money to buy up mortgages from banks, lubricating the mortgage market by giving lenders more money to loan to more buyers. Investors believed their independent but "government sponsored" status implied a federal guarantee for their investments. Fannie and Freddie also repackaged and sold mortgages as the infamous mortgage-backed securities that played such a large role in the financial crisis. Some analysts say the companies played the role of both perpetrator and victim—fueling the market for subprime loans by buying up and reselling many of them until the bubble burst, sending lenders toward ruin.
When the crisis hit in 2008, investors sold off Fannie and Freddie as their holdings—mortgages—suddenly lost much of their value. The Bush administration, not wanting to see these huge lenders fail, placed them into “conservatorship” in September 2008. By the end of 2009, the Treasury had injected $110.6 billion into the companies to keep them afloat.
On top of that, the companies hold or guarantee about $5.5 trillion in mortgages, including that $1.6 trillion in direct mortgage debt. Adding that to the federal balance sheet, which some Republicans argue for, would dramatically increase the government's overall debt, which is one reason the White House says that Fannie and Freddie assets and debts should be in their own class, off the official ledger, until they are permanently restructured. (White House Budget Director Peter Orszag once made the opposite argument before joining the administration, when he headed the Congressional Budget Office.)
Regardless of how you count, resolving the debt issue won't be easy. One scenario, which the Obama administration discussed last year, would be to create a “bad bank,” a standard vehicle for cleaning up insolvent lenders. Under such a plan, bad assets—in this case, mortgage-backed securities—are taken over by the government, resulting in a “good bank” that is commercially viable. (A separate debate is likely to emerge as Democrats and Republicans spar over whether the “good bank” should be independent or linked to the federal government.)
The losses the federal government might take from a bad bank are hard to predict, experts said, because housing prices, which ultimately determine the value of mortgage-backed securities, are still in flux. But a mortgage market with less investment from Fannie and Freddie would slow the overall amount of money flowing into the market and lead to increases in mortgage interest rates.
Whatever form it takes, the federal government will have to find some solution that ensures Fannie and Freddie’s creditors get all their money back with interest. In particular, foreign governments such as China hold hundreds of billions of Fannie and Freddie securities, so experts say that letting the two companies fall into bankruptcy is not an option.