Financial news outlet CNBC was reporting early Thursday that Freddie Mac and Fannie Mae, the two corporations around which much of housing recovery has been structured, may be technically insolvent.
The claim came from William Poole, former president of the St. Louis Federal Reserve, follows a stock market trading day in which Freddie and Fannie stock resumed the free-fall it had started earlier in the week when Lehman Brothers speculated that changes in accounting rules would require that the two government sponsored enterprises (GSEs) raise even more significant amounts of new capital than had been previously thought. In a market which was plummeting in all sectors, finishing the day down over 230 points, Freddie's shares were off 24 percent on the New York Stock Exchange, closing at $10.26 while Fannies' dropped 13 percent to $15.31.
Poole told Bloomberg News that Congress should recognize that the two are technically insolvent
and the odds are that the U.S. may have to bail them out. Others disagreed, saying that there would have to be sudden losses of $40 billion between the two to trigger insolvency.
Meanwhile, the Wall Street Journal is reporting that the Bush administration has been holding talks for months about what to do should either of the two GSEs fail.
The paper says that the government doesn't expect the corporations to fail and no rescue plans are imminent. The talks are part of "normal contingency planning" that the Treasury Department and federal regulators regularly undertake, but that these talks have become more serious recently.
The viability of the two corporations is critical to policymakers because of their key role in the housing market. They own or guarantee about $5 trillion of mortgages which equates to about one-half of outstanding U.S. mortgage debt. The two are currently $1.5 trillion in debt.
While many analysts are saying that the two cannot be allowed to fail, any attempt on the part of the government to help at this point would set off some wild partisan fights on Capitol Hill. Republicans have long sought to put constraints on the GSEs saying that their presumed safety net ' the federal government ' gives them an unfair advantage in the mortgage market and Treasury Secretary Henry Paulson has, in the past, denied any government intention to guarantee Freddie or Fannie's debt.
However, the assumption that Uncle Sam will be ready to step in should things get bad enough has allowed the GSEs an advantage which allows them to borrow money at better rates. Even in the midst of the current mess the companies have been able to get credit at relatively low cost. On Wednesday Fannie Mae issued a series of two-year bonds that were priced only 0.74 percentage points higher than the yields on comparable Treasury bonds about double the usual disparity.
While it appears most likely that Freddie and Fannie will continue to raise capital from private investors, other options open to help them include a credit line from the Federal Reserve, a federal guarantee such as the administration insists won't happen, or an actual equity investment in the companies by the government.
According to the Journal, "Fannie and Freddie are trapped in a vicious cycle. The companies will have to raise capital through stock sales, and the multibillion-dollar amounts they have to raise could result in a massive dilution of shareholders' equity. In anticipation, investors have been dumping the shares, driving their prices sharply lower. And the devalued currency of Fannie and Freddie shares means they will have to sell even more shares."
Freddie's viability is of more concern than Fannie's. When the Office of Federal Housing Enterprise Oversight (OFHEO) which currently functions as regulator of the two companies stipulated that one criterion for reducing surplus capital requirements for the GSEs earlier this year was that the companies raise additional capital, Fannie raised $7.5 billion right away, while Freddie is still waiting to get registered with the U.S. Securities & Exchange Commission, and wants to resolve past accounting issues before it does. In May, Freddie said it planned to raise $5.5 billion through issuing a combination of common and preferred stock.
At the open on Thursday Fannie Mae's stock was down $2.88 to $12.33 and Freddie's fell another $1.60 to 8.67.