Wednesday, October 27, 2010

The Cost of the Fannie Mae and Freddie Mac Bailouts

The Financial Times: Fannie & Freddie ‘Could Cost US $363bn’

BBC News: Freddie Mac and Fannie Mae Bailout ‘To Double’
The Wall Street Journal: Fannie, Freddie Elicit Grim Forecast
The Wall Street Journal: Regulator for Fannie Set to Get Litigious
Wikipedia: Fannie Mae

Some of the United States public has recently criticized the Federal Government over the bailouts of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are mortgage finance companies that operate within the United States. Fannie Mae and Freddie Mac provide a secondary market for mortgage loans. They buy mortgages from big U.S. banks, totaling billions of dollars. Fannie and Freddie then repackage the loans and sell them to investors with a guarantee. The majority of investors believe that there is an implicit federal guarantee of both Fannie Mae and Freddie Mac’s securities, and in the event of a default the Federal Government would intervene. Fannie Mae and Freddie Mac were severely affected during the global financial crisis; they sustained massive losses on the delinquent and defaulted mortgages which they had underwritten.

In 2008, in the midst of the financial crisis, the Federal Government set up a conservatorship for the entities, meaning that the Government pledged to subsidize Fannie Mae and Freddie Mac, enabling the entities to whether the crisis. In return, the entities promised to pay 10% dividends on the subsidized funds. The Government subsequently poured around $148 billion into Fannie Mae and Freddie Mac.

Last February, the White House’s Office of Management estimated that the U.S. Treasury would have to provide another $160 billion to Fannie Mae and Freddie Mac in order for them to stay afloat until 2019. The White House noted that in order for this figure to be accurate, the U.S. economy would have to continue to recover from the financial crisis. However, by this August the Congressional Budget Office had already increased the estimate of the needed federal subsidies to around $390 billion. This week, the Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator, stated that the lowest amount possible that the entities would need is an additional $221 billion. The FHFA also stated that in the worst-case scenario, Fannie Mae and Freddie Mac would need around $363 billion. The actual amount of funds the entities will need largely depends on the strength of the economy and many other factors, such as interest rates, unemployment rates, and the housing market.

As Fannie Mae and Freddie Mac try to stabilize their operations and regain their independence, there may be repercussions for the banks that caused many of Fannie and Freddie’s problems. The FHFA subpoenaed some of the financial institutions this July, trying to discover exactly how much information the banks had on the mortgages they sold to Fannie and Freddie. The FHFA then selected a well-respected law firm to investigate whether a lawsuit would be successful against the banks for selling toxic loans to Fannie and Freddie. A suit would likely allege that the banks breached promises to Freddie and Fannie about the quality of the mortgages they were selling to the entities. If the FHFA can show that the banks breached their promises to Freddie and Fannie, the court would force the banks to buy back the loans at their original value, leading to the recovery of billions of dollars. If the FHFA is successful in its lawsuit against the major banks, it could open the door for other investors to pursue similar claims.

1. Why do the amounts of funds the Federal Government estimates Fannie Mae and Freddie Mac need greatly vary?
2. Besides opening the door to similar lawsuits, what would be some consequences of Fannie Mae and Freddie Mac bringing a successful lawsuit against major lending financial institutions?
3. Should the U.S. Government continue to provide Fannie and Freddie with funds? What would happen if the Federal Government decided to terminate the funding

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