Freddie Mac and Fannie Mae Placed Under U.S. Government “Conservatorship”

In what has been described as the world’s biggest emergency nationalization ever, the U.S. government stepped in once again to rescue ailing mortgage giants Freddie Mac and Fannie Mae. However, this time round it is not just a bail out, but a complete take-over, or what authorities are calling a “conservatorship”. Understandably, Freddie Mac and Fannie Mae shares took a plunge, but the general market rally yesterday may indicate that many investors are hopeful that this move by the federal government could mean the end of the ongoing credit crunch.

As is the case with any controversial strategy, the federal take-over of Freddie Mac and Fannie Mae has its supporters as well as its fair share of critics. Considering the fact that some months back, U.S. Treasury secretary Hank Paulson had expressed his confidence that a measure of this magnitude would not become necessary, investors are left to speculate what this means for the U.S. housing market, as well the implications for the wider economy both in the U.S. and across the Atlantic.

Fannie Mae’s long history is rooted in Franklin D. Roosevelt’s New Deal policy, which aimed to deal with problems created by the Great Depression of the early 30s through providing relief to the unemployed, aiding the recovery of the economy and reforming the banking systems. The Federal National Mortgage Association, nicknamed Fannie Mae, purchased mortgages from the lender and sold these in the form of bonds to investors, thereby providing the original lender with the liquidity to grant more mortgages loans. Even after the privatization of Fannie Mae by Lyndon Johnson in 1968, investors viewed Fannie Mae’s bonds as safe as if they had been issued by the government itself. During the U.S. economy’s downturn associated with the Vietnam war, the Federal Home loan Mortgage Association, nicknamed Freddie Mac, was formed as a direct competitor to Fannie Mae, and although they were both private corporations having ordinary shareholders, they had the status of being “government-sponsored enterprises” as chartered by Congress. This status effectively meant that they had access to discounted funding and carried the implied promise of government support if they fell into trouble. These two government-sponsored enterprises were the means by which millions of citizens fulfilled the American dream of home ownership.

A common misconception is that Fannie Mae and Freddie Mac caused the sub-prime crisis, but this is not the case. The U.S. financial sector created the situation the market now finds itself in by lending to borrowers who clearly did not even come close to meeting the standards of credit worthiness – and continuing to do this extensively and indiscriminately. As a secondary market to the sub-prime industry, Fannie Mae and Freddie Mac were in effect exploited by the financial sector. As sub-prime collapsed, the mortgage market closed and house prices sank, thousands of borrowers found that they were unable to meet their financial obligations and foreclosures started to become an everyday occurrence. By late August, Fannie Mae and Freddie Mac were showing a combined net loss of around $15 billion, their shares had dropped drastically and rating agency Moody’s downgraded their bonds to the status of “junk”.

While it is possible that this government conservatorship will be temporary, how temporary is anyone’s guess. The U.S. government has allocated a capital amount of up to $200 billion in an attempt to rectify the situation, chief executives and the board of directors of both companies will be replaced by Treasury staff, and shareholders in all likelihood have lost their money. However, as investors who keep the U.S. mortgage market going, bondholders will be in a better position seeing as the credit of the two mortgage companies can now be considered to literally be as good as that of the U.S. government itself.

Theories and speculation abound as to what impact this unprecedented rescue mission will have on the U.S. housing market and global economies and the coming weeks will certainly be interesting for all in the financial and investment world.