Economist's Commentary: July 10, 2008

Fannie and Freddie Troubles

By Lawrence Yun, Chief Economist

The stock prices of mortgage giants Fannie Mae and Freddie Mac have taken a severe whiplash beating in the past week, with some questioning their survival. In a Q&A format, here's what's going on:

Why are share prices falling?
Fannie and Freddie share prices have plummeted on fears that they will implode because of rising mortgage defaults driven by home price declines.

What are mortgage default rates on loans held by Fannie and Freddie?
According to the Wall Street Journal, Fannie has reported that 1.22% of the single-family loans it owns or guarantees were 90 days or more overdue in April, up from 0.62% a year ago. For Freddie, the delinquency rate is 0.81%, up from 0.49% a year earlier.

I am not a shareholder of these companies, so why should I care?
Fannie and Freddie are involved in $5 trillion-worth of mortgage debt business, which is equivalent to the size of the current federal government debt held by the public. The numbers are huge. To put it into perspective, the $5 trillion translates into $16,000 for every American living in the country.

What happens if they collapse like Bear-Sterns?
Mortgage rates will rise much higher and this will hurt consumers and home sales.

Will they collapse?
Not likely. OFHEO, the independent regulator for Fannie and Freddie, has said that the companies have enough capital to withstand extreme conditions.

What if the extreme case occurs and capital runs out?
Then Fannie and Freddie will need to raise more capital by issuing stocks. Given the belief that Fannie and Freddie will be backed by the government, the cost of raising capital should be easy. The issuance of more stocks however hurts existing shareholders because the ownership gets diluted. The current stock price decline is due to the belief that Fannie and Freddie will need to raise capital. The taxpayers are not impacted - at least if this raising of capital is sufficient to carry on the business and marks the end of the current woes.

What happens if home prices fall much further than anticipated and the newly raised capital runs out or stock prices fall to zero?
The federal government will take over the company (without a doubt) and take on all the mortgage debt default risk.

Does this mean that the U.S. government and the taxpayers will lose $5 trillion?
No, the U.S. government may lose some money or even possibly make money if defaults slow down. After all most mortgages will remain current and the government will collect those payments.

But, I keep hearing that $5 trillion in taxpayer money is at risk if Fannie and Freddie go under. True?
No, this is impossible. The $5 trillion of debt will be on government books with the possibility of the government actually making money if mortgage payments can offset defaults. The $5 trillion would be lost only if all mortgages are written off. This assumes everyone no longer pays mortgages.

What is the worst possible case? Let's say no one pays mortgages anymore. Then the taxpayers are on the hook for the full $5 trillion. However, that is also $5 trillion in debt relief to homeowners or could even be viewed as a $5 trillion tax cut. If I don't have to pay my mortgage, I have more spending money. The economy will rev-up on consumer spending over the short-term. However, the long-term damage will be the high cost of borrowing from mistrust in the financial market. Without the capital in CAPITALISM, the economy will be hard pressed to fund new projects and businesses. We will become a static, not dynamic, economy.

Does it matter if the government takes over Fannie and Freddie?
I do not have enough information to evaluate fully. Right now, I do not think it matters over the short term. The long-term impact could be the "inefficiency" of a non-profit organization running a mortgage business - and somewhat higher cost of mortgages.

On the discussion of insolvency - read more here >

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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