In September 2008, the U.S. government initiated a significant intervention in the financial markets by taking control of Fannie Mae and Freddie Mac. This action, described as one of the most sweeping government interventions in private financial markets in decades, was a direct response to the escalating subprime mortgage crisis. The Federal Housing Finance Agency (FHFA) placed both government-sponsored enterprises (GSEs) into conservatorship, aiming
to stabilize the financial system and prevent a broader collapse. This move highlighted the critical role these entities played in the U.S. housing finance system and the severe pressures they faced.
The Genesis of Conservatorship
The decision to place Fannie Mae and Freddie Mac into conservatorship was announced on September 7, 2008, by FHFA Director James B. Lockhart III. This announcement followed reports that the federal government was preparing to take over the two entities, with meetings held with their CEOs on short notice. The immediate goal was to ensure the normal functioning of business on September 8, the first business day of the conservatorship, by providing stronger backing for holders of mortgage-backed securities (MBS), senior debt, and subordinated debt. This intervention was deemed necessary due to combined GSE losses of US$14.9 billion and market concerns about their ability to raise capital and debt, which threatened to disrupt the U.S. housing financial market.
The Treasury committed to investing as much as US$200 billion in preferred stock and extending credit through 2009 to maintain the solvency and operations of the GSEs. At the time of the takeover, Fannie Mae and Freddie Mac had over US$5 trillion in outstanding mortgage-backed securities and debt, with the debt portion alone amounting to US$1.6 trillion. The conservatorship was designed to protect the senior and subordinate debt and the mortgage-backed securities of the GSEs, while common stock and existing preferred shareholders were expected to bear any losses before the government.
Initial Actions and Market Reactions
Upon assuming conservatorship, the FHFA took several immediate actions. The Chief Executive Officers (CEOs) of both Fannie Mae and Freddie Mac, Daniel Mudd and Richard Syron respectively, were dismissed but remained to assist with the transition. Herbert M. Allison, former vice chairman of Merrill Lynch, was appointed CEO of Fannie Mae, and David M. Moffett, former vice chairman of US Bancorp, took over Freddie Mac. Their compensation was significantly reduced compared to their predecessors. To conserve capital, common stock and preferred stock dividends were eliminated, though the stocks themselves remained outstanding. Subordinated debt interest and principal payments continued.
Furthermore, all political activities, including lobbying, were immediately halted, and charitable activities were put under review. A crucial element of the intervention was the establishment of a financing and investment relationship with the U.S. Treasury through three different financing facilities. These facilities were intended to provide critically needed support not only to Fannie Mae and Freddie Mac but also to the 12 Federal Home Loan Banks regulated by the FHFA, ensuring liquidity in the broader mortgage market.
The financial markets reacted swiftly to the news. On Monday, September 8, the day after the seizure, reactions in finance markets indicated satisfaction with the short-term implications of the Treasury's intervention. The Governor of the Bank of Japan, Masaaki Shirakawa, expressed expectations that the action would stabilize the U.S. mortgage-backed securities market, the financial market, and the international financial market. Similarly, Zhou Xiaochuan, Governor of the People's Bank of China, viewed the development as positive.
Impact on Financial Instruments and Institutions
The conservatorship had notable consequences for various financial instruments and institutions. Many commercial banks in the United States held preferred shares of Fannie and Freddie. With the suspension of dividends and the junior status of these shares to the senior preferred stock issued to the Treasury, the market value of these preferred shares plummeted. This required banks to write down the value of these holdings, exacerbating capitalization concerns for some U.S. banks. For instance, Gateway Bank agreed to be acquired by Hampton Roads Bankshares Inc. to offset a $40 million writedown on its Fannie and Freddie stock, which had pushed it below regulatory capital requirements.
In the credit default swap (CDS) market, the placement of Fannie Mae and Freddie Mac into conservatorship was defined as a credit event, triggering the settlement of outstanding contracts. These derivatives are used to hedge or speculate on the risk of a company defaulting on its bonds. With approximately US$1.5 trillion in bonds outstanding from the two GSEs, and an estimated US$500 billion in related CDS contracts, this settlement was anticipated to be the largest in the market's history. Paradoxically, the value of the GSE bonds rose to near par value after the conservatorship, meaning some swap owners hedging against default might have been worse off. Cash auctions were scheduled for October 2008 to settle these CDS contracts.
The Broader Goal: Stabilizing the Mortgage Market
The government's intervention was fundamentally aimed at supporting the soundness of obligations and guarantees on securities issued by Fannie and Freddie, which were crucial for obtaining funds used to purchase mortgages from originating banks. The anticipated reliability of GSE obligations was expected to enhance market liquidity in several ways. Banks could be assured that Fannie and Freddie had the necessary funds to purchase conforming loans, thereby encouraging increased lending and improving liquidity in the mortgage market, potentially lowering interest rates. Lower borrowing costs for banks were also expected to increase profitability, further shoring up bank liquidity and balance sheets.
Additionally, the intervention sought to reduce adjustable rate mortgage (ARM) rates, alleviating pressure on homeowners and decreasing foreclosures. Lower rates were also intended to stimulate new home purchases. The government's role as the primary investor allowed for the implementation of a systematic loan refinancing process, enabling rapid loan adjustments or workouts for homeowners who had faced bottlenecks due to the need for multiple investor approvals. This included the potential for rapidly pushing down 45-year mortgage terms and fixed, low interest rates, which was expected to significantly reduce foreclosures and help stabilize home prices. The ability to restructure mortgages to current market values was also considered, reducing the incentive for homeowners to abandon their properties and providing upward support for the value of mortgage-backed securities.
