The Heavy Load of Fannie and Freddie

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Just as Congress passed the financial reform bill to prevent another financial meltdown, top government officials are currently trying to unwind destruction in the housing market from 10 years of over-stimulation - and trying to prevent another systematic failure.

That's right, the subject of who makes loans and who gets loans are both at the center of the debate.

If you were looking for specific small cap investment ideas today, stop reading now. I don't have them. But if you're interested in understanding one of the major factors that will determine market direction over the next couple of years, I encourage you to read on. We'll get back to specific stocks later this week. Housing is a hugely important issue, and you need to know what's going on.

***Yesterday, the Obama administration, led by Treasury Secretary Tim Geithner and Secretary of the Department of Housing and Urban Development (HUD) Shaun Donovan, began discussing how to repair the housing finance system. The conference represents a first step in developing a new approach to lending in the U.S.

Central to the discussion is how head officials can decrease the impact of future recessions on the housing market. As you likely know, back in September 2008 our government took over Fannie Mae ( FNMA ) and Freddie Mac ( FMCC ) - two organizations (notice that I did not call these shell organizations 'companies') that are now at the center of the debate.

Ok, maybe I will mention two small caps. Fannie Mae and Freddie Mac both have market caps under $400 million. Problem is they both have enterprise values over $2 trillion . No typos here. Recall that enterprise value is a company's market cap, plus debt, less cash. It's essentially what a private equity firm would pay to take a company private.

Point is these are shell companies - bound to fail but propped up by a failed mortgage finance system. Check out these companies' 5 year charts - any takers out there?

To understand where lending could be headed, you must understand how we got into this mess. Back in 1992, Congress passed an act that essentially forced Fannie Mae and Freddie Mac to make housing affordable. Their mission was to provide liquidity and stability in the mortgage market. These 'companies' would buy mortgages and package them into securities with a no-default guarantee.

They then began issuing mortgages, many to low-income Americans who could barely afford their monthly payments. Why? Because big government decreed that home ownership was a right.

***The question now is whether or not the government should continue funding these companies to provide stability in the housing market. Or should the government reduce its role and allow a private market to take over. Call me a cynic, but I think the folks at Merriam-Webster have already crossed out the term 'free market' for their next dictionary release. But I digress...

Tim Geithner believes the government could remain involved in the mortgage market - guaranteeing money to investors in mortgage-backed securities regardless of whether or not the borrowers default.

But he also said that Fannie and Freddie will undergo "fundamental change". Geithner even went so far as to state the possibility of giving these two companies an "elegant funeral" - implying this would eliminate the government's role in the housing market.

But many analysts oppose this idea, saying that the government plays a significant role in the housing market, especially during economic downturns like the one we've been in the last two years.

Geithner concurs: "Without such support [from the government], the risk is that future recessions could be more severe because the financial system would not have the capital to support mortgage lending on an adequate scale".

Mark Zandi, economist at Moody's Analytics, discussed the repercussions if the government decreased its role saying, "The hit to the economy [from the recession] would have been measurably greater" . His statements indicate that with the government's implicit backing of these mortgage giants, credit was allowed to continue flowing - even as home prices plummeted and private sector lending dried up.

***Top officials heard both sides of the debate yesterday. Republicans stressed the importance of limiting the government's role in the housing market while Democrats advocated government spending in order to provide stability - and give the average American an opportunity to own a home.

The debate will only gain momentum in early 2011 and could determine if, and how quickly, the housing market, and thus the economy, will recover.

A few weeks ago Fannie Mae requested around $1.5 billion in funding after reporting a second quarter loss of $3.1 billion. Freddie Mac is in the same situation. The company had $118 billion in bad loans in the most recent quarter, up from around $15 billion at the end of last year. It also reported that it owned more than 62,000 foreclosed properties, up from just 35,000 a year earlier.

What to do, what to do...

Obviously these organizations aren't viable institutions - so the choice becomes (1) do nothing and keep the 'shells' until the debt can be wound down, or (2) take action to move the government further away from the center of housing finance.

If the government totally pulls out of the housing and lending markets, that could hurt the economic recovery and credit could dry up. It could also have a negative impact on the stock market, as investors will most likely be turned off by the news of a credit crunch. But if it stays in, then nothing changes.

***I don't think this is an all-or-nothing decision. According to the Mortgage Service News, Fannie, Freddie, and Ginnie Mae (the Government National Mortgage Association) were behind 98 percent of all mortgages in the U.S. so far this year. Some are worried that eliminated any support to these agencies is like pulling the rug out from under the entire housing market.

There is no way government can get its act together to offload trillions of dollars in mortgage debt, and billions in bad loans, in an orderly fashion all at once. And no private institution would take on that level of risk. What we would wind up with is literally thousands of organizations, many of which would likely be hedge funds and private equity funds, taking comparatively large bets on the future of housing prices and interest rates.

That's not a scenario I favor - even though I'm a staunch advocate of 'free' markets. This mess is too big, too deep, and too pungent to shovel onto the private sector in short order.

I believe we are in for a long transition period during which Fannie and Freddie (or some similar shell organization) will exist to house the majority of mortgage debt. We need a disciplined step down plan through which government's over-control of the housing market is wound down. Let's start with reducing government mortgage debt ownership from 98 percent to 90 percent, then 80, then 70 - for starters.

The precedent for public-private partnerships has already been established - not only in the housing market but in all types of organizations ranging from natural resource protection to technology development. No need to reinvent the wheel right now.

The complexity of this problem will most likely be solved by similar means - bringing the private and public sector back together and transitioning ownership, and responsibility, from one to the other. But that won't happen quickly.

Expect this huge economic challenge to be a major driver, both up and down, of market direction for the next several years. I can't tell you how it will end, but I will keep you updated as it unfolds.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: FMCC , FNMA

Wyatt Investment Research

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