Fannie, Freddie and me

Finance expert comments on the mortgage giants' federal bailout and the impact on taxpayers, shareholders, the mortgage market and the confidence of the American people

Now that the U.S. government has taken the controls of distressed mortgage giants Fannie Mae and Freddie Mac, American taxpayers facing billions of dollars in losses in home loans issued by the private sector are left wondering, “What does this mean for me?”

“This is a very uncertain situation for taxpayers in the short term,” says Radhakrishnan Gopalan, assistant professor of finance at Washington University in St. Louis. “Hopefully, there will not be a major impact in the long term. The government funding is senior to the existing equity of Fannie and Freddie, so if the housing market recovers, the government will be in line — before the existing shareholders — to get its money back. Hence, there is a better-than-average chance that the government will be able to recover its investment.”

Below, Gopalan comments on shareholder impact, the Treasury’s steps going forward and the people’s trust in the financial services sector.

How will Fannie and Freddie shareholders be impacted?

Existing shareholders of Fannie and Freddie would lose out as the Treasury is unlikely to support the two firms so as to benefit the existing shareholders. The current proposal does not wipe out existing equity, but government will get paid before the existing shareholders see any money. So for existing shareholders to make money on their investment, the housing market has to recover drastically.

What steps might the U.S. Treasury take going forward?

In the short term, Fannie and Freddie are likely to be more aggressive in funding mortgages. This will remove one major uncertainty in the overall market and help the mortgage market. The companies also can reduce their overheads in areas such as employee compensation and lobbying efforts to make themselves more lean and efficient.

But in the long term, Fannie and Freddie cannot return to business as usual. The structure of government-sponsored private firms is a contradiction in terms, and the current crisis has enabled the authorities to address this. The next administration has to take a serious look at Fannie and Freddie and their utility with our current state of capital markets. The ideal option would be to gradually downsize them, limit their activity to only those sectors where there is a genuine need for government support for mortgage finance and let the private sector take over the financing of most mortgages.

Does government intervention mark a first step toward nationalizing our financial services sector? What will it take to restore the health of Fannie and Freddie?

Fannie and Freddie have grown so big that the government could not have allowed them to fail. Although these firms are private, they have always worked under an implicit government guarantee. Investors buying the debt of Fannie and Freddie have always been under the impression that the U.S. government would step in if these organizations got into trouble. The key indicator that triggered the current bailout was the fact that mortgage defaults were increasing and private investors were reluctant to put any equity into these firms given the uncertainty about government bailout. The current crisis is a blessing in disguise as it helps address the problems of Fannie and Freddie, which were always an anomaly.

In light of the subprime lending crisis, auction-rate securities fraud and other debacles, what will it take to restore people’s trust and confidence in the financial services sector?

It is true that investors have significantly lost confidence in the financial services sector. When this occurs, the people who were in charge during the troubled times lose their jobs. After the initial house cleaning, the firms themselves have to be introspective and put checks and balances in place that will offer sufficient assurances to outside investors that the mistakes will not happen again.

The government can also help in this regard with suitable regulation. The SEC has already come up with a report and some regulation for rating agencies, and there is talk of regulating mortgage brokers who were responsible for originating some of the worst mortgages.

Interestingly, it is not true that all investors have lost complete faith in the financial services sector as all the banks have been very successful in raising bucket loads of cash, mainly from outside governments, to shore up their capital. Such capital is knowledgeable capital, and its inflow indicates that the banks and institutions have managed to convince the investors that the mistakes will not happen again.