Shareholders in Fannie Mae and Freddie Mac got screwed when the government nationalized Fannie and Freddie; the government held the debt in Fannie and Freddie, and no shareholder could put up a fight. USG was a bond holder with the power of the mint. The government saved Fannie and Freddie from bankruptcy for one specific reason: the market for mortgages was about to disappear; the price of mortgages on the secondary market could not be determined. Nobody knew what a loan was worth. This became apparent when the spread between the 30 Year US Treasury Bond and the 30 Year Mortgage Interest Rate skyrocketed in the summer of 2008. As The Balance notes,
“Despite the bailout, mortgage rates continued to rise. By August 22, 2008, rates on a 30-year mortgage were 6.52 percent. That was a 30 percent increase since March and the same as a year ago. Rates rose despite a decline in U.S. Treasury bond yields. Those fell as investors fled to the safety of government-backed bonds. (Bond yields fall when demand for the underlying bond rises.)”
This was an ominous sign, and ultimately, this meant that without the liquidity that Fannie Mae and Freddie Mac provided, the mortgage market would not stabilize. At this point, in August of 2008, Fannie Mae and Freddie Mac,
“…held or guaranteed more than $5 trillion, or half, of the nation’s mortgages.” (The Balance)
At that size, Fannie and Freddie had essentially monopolized the secondary market for mortgages. Fannie and Freddie were failing, government granted monopolies. It’s no surprise they were monopolies; no other company could possibly compete unless they too had a government guarantee to fall back on.
Mortgage rates were set to skyrocket to some unknown level, while the risk-free rate was set to plummet. The spread between the mortgage rate and the US Treasury 30 Year Bond, a measure of risk in the lending market, was widening (getting bigger). The bigger the spread (difference), the more implied risk in the lending market. If mortgage rates were to continue to rise, home prices would continue to decline. There would come a point when homeowners who were completely solvent and paying their mortgages (non-subprime mortgages) would begin to foreclose on their properties. Why? Because the homes would have been worth far less than the loan. Paying your mortgage would be the same as lighting money on fire; no one wants to pay a fixed price for something that is depreciating (losing value) everyday. It turns out, many homeowners in the most hard-hit housing markets did just this; they took their keys to the bank and turned them in, saying they were done paying their mortgages.
Ultimately, we can go as far to say that the entirety of Wall Street felt they had a US government guarantee. This is where the concept of “Too Big to Fail” came from. Banks felt that they could off-load risk to Fannie and Freddie at any time; this meant the risk was in NOT originating as many loans as humanly possible; remember, mortgages, and loans in general, are huge business for banks because of the fees they generate, and the investors they attract once they’ve been securitized. The risk was in taking too little risk, as opposed to taking too much. The business model of the “private corporation with government guarantee” ultimately guarantees nothing but excessive risk taking, which often ultimately leads to the crashing down of the House of Cards, so to speak.
I got a good laugh out of the following from The Balance,
“The Federal government stepped in to restore that trust by promising to bail out bad loans. It was meant to keep the housing slump from getting worse. Unfortunately, it was all funded by the U.S. Government, which already had a $9 trillion national debt.”
The “stepping in” referred to the final step the government took, which was the nationalization, or conservatorship, of Fannie and Freddie. The laugh I got because today the national debt is $21 trillion. The method the bail-out was conducted was two-fold; one part of it was an actual nationalization, where the government stepped in and injected cash into Fannie and Freddie so that they could continue to guarantee loans. The consequence of this was that shareholders were wiped out, but bondholders were saved. This is similar to what happens in a corporate bankruptcy. The bondholders were the people holding the securitized loans. Who were they? Well, they were Fannie and Freddie mostly, but they were also other investors who had bought securities from Fannie and Freddie, and from other much smaller secondary markets. Because of the proliferation of MBSE, the US government bail-out of Fannie and Freddie put a floor on the prices of MBSE, saving investors worldwide, a lot of money. It also put a floor on the price of the assets backing those loans: US homes. The second part of the bail-out is explained in the following excerpt from The Balance:
“The Federal Reserve agreed to take on $200 billion in bad loans from dealers (actually, hedge funds and investment banks) in exchange for Treasury notes. Last, but certainly not least, the Fed had already pumped $200 billion into banks through its Term Auction Facility. In other words, the Federal government had guaranteed $730 billion in subprime mortgages, and the bank bailouts were just getting started.”
Term Auction Facility was a way for banks that were not in trouble, banks that were perfectly sound financially, to borrow money from the Fed. Why was this necessary? Because good banks during the crisis were essentially closing their doors to other banks. It’s necessary to understand that the Inter-Bank Lending market is a CRITICAL component of the US banking system. If banks don’t borrow money to each other, then money stops moving. This is what happened during 2007 and 2008. Nobody knew who was a good bank, and who was not. Furthermore, even though the Federal Reserve was lowering interest rates, which included something known as the “discount rate” (banks could borrow from the Federal Reserve at nearly 0%), no bank wanted to be the first to do it. Why? Because the Federal Reserve discount window is a lender of last resort; if a bank was forced to the discount window, that meant NOBODY else wanted to lend them money, which meant they were very likely in a huge pickle. What happens when word gets around a bank is in trouble? The vultures swoop, the bank gets run on, and things spiral out of control. This is why later on, the Federal Reserve and the US Treasury actually forced all of the large banks to take capital injections. From Boston.com,
“…it resulted in the government taking direct stakes in the banks through $125 billion in preferred stock purchases – marked a shift in the government’s strategy to fixing the financial system…The Treasury had first decided to use a chunk of the $700 billion financial bailout package to pay for taking partial ownership stakes in banks, rather than use the money to buy rotten debts from financial institutions. The idea was that the investments would instill confidence in the system and get banks to lend again, following the credit-market freeze.”
Couple things to elaborate on here. First, the $700 Billion bailout was officially named the Emergency Economic Stabilization Act of 2008. The fact that the bank’s resisted taking money from the government should not be a surprise. To them, a government take-over of the banking industry symbolized an insult to capitalism, especially since the banking component represents the capitalist backbone. With that said, the heads of the banks were talking their books; they weren’t necessarily concerned about some greater capitalist good. We know this because the banks had been completely kosher with the Federal Reserve, Fannie Mae, and Freddie Mac, taking bad loans off their books. That too was a form of government intervention, except that it let banks win, without having to take any responsibility for the mess. This was the ideal situation for banks; this was their idea of an acceptable government-guarantee. Of course, part of the idea behind the bailouts was to make a political example of banks, and so the above noted forced preferred stock purchases made that possible. As a preferred stock holder, the US government now had a say in how the banks were run. As a preferred stock holder, the US taxpayer had a say in the future of the banks. That paved the way for the strict regulations and laws on banking that proceeded.
By the way, when we say, “the banks”, we should specify who they were. The Boston.com article gives us a list of the first 9 banks that were nationalized:
“Banks that were initially required to accept the funds were Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co., Citigroup Inc., Wells Fargo & Co., State Street Corp., Bank of New York Mellon, and Bank of America Corp., including the soon-to-be-acquired Merrill Lynch.”