As part of its semi-annual report to Congress, the Federal Housing Finance Agency's (FHFA) Office of the Inspector General (OIG) included a section detailing, in financial terms, the fall of the two government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which were placed under FHFA conservatorship in September 2008.   The GSEs' fall was both swift and devastating so it is helpful to see, in one place, the numbers and the time-line underlying their implosion.

Background

The GSEs' historic mission was to provide liquidity to the housing finance system.  They did this primarily by supporting the secondary mortgage market through the purchase of residential mortgages from originators who then used the proceeds to originate more loans.  The GSEs either held the mortgages in investment portfolios or packaged them into mortgage-backed securities (MBS) they then sold to investors.  For a fee the GSEs guaranteed the performance of the MBS they sold.  GSE operations were financed through MBS sales and through funds borrowed from large individual, institutional and foreign investors.

Because some homeowners will inevitably default on the mortgages the GSEs hold they maintained special accounts or reserves to which they made regular contributions called provisions for loan losses.  In the case of the guarantees for loans associated with MBS, the fees they charged for their guarantees were intended to cover the small subset of loans that were expected to default and reserves were established for those losses.

When a homeowner does default, the loan servicers may commence foreclosure and take possession of the collateral property.  When this process is completed the GSE erases or charges off the unpaid mortgage balance, debiting the corresponding loss reserves.  If the collateral property is subsequently sold the proceeds will offset losses. 

The GSEs aimed to sufficiently contribute to their loan and guarantee portfolio reserves to cover expected losses.  However, when the housing market collapsed, losses on loans and guarantees vastly exceeded that loss-covering capacity.

The Crisis

Between 2001 and 2006 the US housing market experienced a "housing bubble" wherein the prices of single-family homes increased an average of 12 percent each year.  This increase was accompanied by mortgage debt that more than doubled from $5.1 trillion in 2000 to $11.2 trillion by June 2008.  In about the same time frame Fannie Mae's mortgage-related assets and guarantees went from 1.3 trillion to $3.1 trillion and Freddie Mac's from $1 trillion to $2.2 trillion (representing annual increases of approximately 11 percent for each GSE.)  Then, starting in 2007 home prices began to plummet and defaults to rise.  After more than doubling over six years, home prices fell by 27 percent between 2006 and 2008.

The GSEs had grown rapidly with only a thin capital cushion to provide protection against losses.  The capital they were required to hold met regulatory standards but fell well below the capital levels maintained by many large financial institutions so they were not prepared to manage the sharp decline in housing prices.  In 2007, with prices down an average of 9 percent, the GSEs businesses began to feel increasing stress and by the next year rates of seriously delinquent mortgages they either owned or guaranteed exceeded any levels of the previous decade.

Gains, Losses, and the Use of Funds

Fannie Mae lost $5 billion in the second half of 2007 and another $4.5 billion in the first half of 2008 and Freddie Mac lost $3.7 billion and $1 billion.  Then the collapse of the MBS market in the Fall of 2008 resulted in even larger losses.  During 2008 the two GSEs had combined losses of more than $100 billion.  For some perspective, over the 37 year history of the two companies (1971-2008) they earned $95 billion less than they lost in 2008 alone.  During the next three years ending in Q3 2011 the GSEs lost another $251 billion.  "In other words, the losses incurred during the conservatorships are more than double the cumulative net income the GSEs reported as public companies."

On September 6, 2008, FHFA in concert with the Department of the Treasury put the GSEs into conservatorship citing concerns about their financial conditions, their ability to raise capital and to continue funding themselves, and the critical importance of each company to the residential mortgage market.  At the same time Treasury entered into an agreement to provide the GSEs with cash sufficient to eliminate what deficits they might occur in exchange for ownership of the GSEs senior preferred stock.  Since that time Treasury has made equity investments in the GSEs every quarter and, by the end of 2011 the cumulative amount was $185 billion.

Initially the Treasury's investment was capped at $200 billion, subsequently increased to $400 billion and increased again to $400 billion over the amount actually drawn as of December 31, 2012.  As a condition o this support the GSEs agreed to pay to Treasury quarterly dividends at an annual rate of 10 percent on Treasury's outstanding investment.

According to OIG, these dividend obligations, exacerbated by the 10 percent annual rate, are so large that the GSEs have yet to earn enough to pay them annually so Treasury has had to advance additional sums to pay the dividends.  At the end of 2011, Treasury's $185 billion investment in the GSEs included $32 billion to pay its own dividends.  At present the required annual payment from the GSEs is $19.2 billion.  The two, in their best year, earned a total of $14 billion, so they have never in their history earned enough to cover the required dividend on Treasury's current investment.

As stated above, the GSEs cumulative losses as of the end of Q3 2011 totaled $261 billion, offset by $78 billion in unobligated capital at the beginning of 2008.  The figure below quantifies the relative losses, dividend obligations, and gains of GSE operations through that third quarter.

The GSEs' single-family business line has had a net loss of $208 billion since 2008 after accounting for revenues for new and existing loans.  This represents the bulk of the GSE losses.  Moreover, the vast majority of these losses are attributable to loans made from 2004 through 2008.

During conservatorship the GSEs accrued $86 billion in expenses related to mortgage loans on their books.  However, this sum is affected by an accounting change in 2010.  Prior to that time these losses related only to loans purchased and immediately placed in their portfolios but the change required them to account for loans they had guaranteed in the same was as those they owned and held on their books.  Thus the GSEs reduced their reserve for MBS guarantee losses and increased the reserves for retained mortgage losses.

The GSEs began to rapidly expand their MBS business in the early 1990s.  By 2008 they were guaranteeing mortgages securitized into MBS at a value nearly seven times the amount held in their portfolios.  As the housing market collapsed and homeowners defaulted, the GSEs satisfied their guarantee obligations and made the required payments to MBS investors.  In spite of the 2010 accounting change, the GSEs' provisions for guarantee-related losses have totaled $132 billion during the conservatorships.

Multi-family mortgages in which the GSE participate have contributed a gain of $7 billion from 2008 to the end of the third quarter of 2011 and investments have contributed $4 billion to overall losses.  However, gains through investments have gone to partially offset the $83 billion loss in this category suffered in 2008.

GSE investments consist primarily of private-label MBS and derivative contracts.  The value of private-label MBS, especially those related to subprime, option, and Alt-A loans plummeted in 2008.  In addition, many of the underlying loans were concentrated in states (California, Nevada, Arizona, and Florida) which were particularly hard hit by the crisis.    None-the-less, the heavy losses in 2008 have subsequently been offset by income from the investments and a recovery in value.

Another source of significant GSE losses was the write-down of low-income housing tax credits during the fourth quarter of 2009.  Because they have no taxable income, these credits which had been acquired where there was profit, have no value.   Treasury denied the GSEs request to sell the credits so they were written off which contributed $8 billion of the $16 billion "other losses" recorded in that quarter.

Putting the losses in Perspective

OIG said that in the last quarter before conservatorship (April-June 2008) the GSEs had $1.6 trillion in short-and long-term outstanding debt, $3.7 trillion in MBS guarantees, and stockholders' equity of only $54 billion.  It is unlikely OIG says, that the GSEs could have made scheduled debt payments and satisfied their guarantee obligations without Treasury support.

The big losers from the fall of GSE are the stockholders.  The Treasury-GSE agreement states that no dividends can be paid to them without Treasury approval until Treasury is fully repaid and Treasury has the right to purchase up to 80 percent of the GSEs' common stock at a nominal amount.  This has made the common stock of both GSEs virtually worthless.

The big winners are the holders of bonds and Guaranteed MBS.  By placing the GSEs into conservatorship and committing to capital investments in them, FHFA and Treasury provided assurance that the GSEs would be able to make contractually required payments.  While neither GSE publishes a comprehensive list of creditors they are known to include foreign central banks, commercial banks, fund managers, insurance companies, state and local governments, corporate pensions, individuals and nonprofit foundations which invested in GSE debt and guaranteed MBS.

Further since conservatorship the private sector has almost abandoned the secondary market and the GSEs and Ginnie Mae have stepped up to fill the void.  Treasury's intervention has provided assurance to future investors and creditors and they too will get their money back.

Outlook

On top of the $185 billion invested by Treasury through the end of 2011, FHFA projects three scenarios for future capital draws by the GSEs through the end of 2014.

Under each, the amount of additional support depends on the outlook for home prices - whether they continue to fall, by how much, and for how long - and when and how strongly circumstances turn around so prices begin to increase.  According to the most recent projection in October 2011, estimates of additional taxpayer financing for the GSEs range from $37 billion to as much as $128 billion which would bring the total support for the GSEs to a range from $220 billion to $311 billion.