Fannie and Freddie Might Need Your Money

And Why Lehman’s Bankruptcy Is Still Not Over

Jul 17, 2018
Finance

SMITH BRAIN TRUST – Ten years ago Fannie Mae and Freddie Mac emerged as a major worry in the financial sector, one that would require a massive bailout from the federal government and placement into conservatorship.

Now the two government-sponsored enterprises (GSEs) could again become a source of jitters. The mortgage-finance giants might soon be forced to draw from the U.S. Treasury because of new loan-loss reserve accounting guidance, says Clifford Rossi, executive-in-residence and professor of the practice at the University of Maryland’s Robert H. Smith School of Business.

Rossi describes Fannie Mae and Freddie Mac as “the final vestiges” of significant reform needed to address what happened leading up to the financial crisis. “They are still under conservatorship. They are still wards of the state. They are in this limbo. They’re still doing what they’ve been doing, but they’re still effectively owned by the federal government,” he says. “And it is just not a good place to be long term.”

Particularly now, with the standards-setting Financial Accounting Standards Board currently altering how financial institutions and investment firms calculate their allowance for loan and lease losses. Under the current model, companies build up a loss reserve over the life of a loan. The new model – known as Current Expected Credit Loss, or CECL – will require companies to record a loss reserve when a loan is originated.

The change places a larger upfront burden on financial institutions – a burden that will be particularly acute for Fannie and Freddie.

Under the terms of conservatorship, Fannie and Freddie must channel their – thus far, sizable – quarterly profits to the U.S. government. They are restricted from holding those assets on their balance sheets, which will make the new loan-loss requirements tough to meet.

One solution is to finally wind down the conservatorship for the two mortgage giants. Several proposals have been floated to do just that. But with the companies returning profits to the government each quarter, there’s been little appetite for making that change.

“There’s nothing quite like a company making a ton of money, and the government getting to keep the profits every quarter,” says Rossi. “Why would you turn those taps off? That’s the attitude.”

The U.S. housing market has been robust in recent years – in large part because of a low interest rate environment that has held 30-year fixed-rate mortgages to 4 percent or below. And, as a result, the mortgage-finance giants have been viewed as posing little risk to U.S. taxpayers.

However, Rossi reminds, taxpayers would be on the hook if another housing crisis erupts. That’s worrying.

“If you look across the country,” Rossi says, “there is an artificial sort of housing bubble in certain markets.” In San Francisco, Seattle and Denver, for example, homes are drawing multiple bids and are selling well above the asking price. It’s a classic sign that a market might be overheating and ready for a downward move in prices – a move often accompanied by a larger-than-normal glut of credit losses.

“Here we are taking all the profits from Fannie and Freddie and putting them in the U.S. government coffers, and leaving them with virtually no capital to protect themselves from a housing downturn,” Rossi says.

It’s short-sighted, he adds. It could leave taxpayers funding another bailout and could stoke investor concern on a global scale. “I don’t think we are looking at a repeat that’s on the magnitude of the 2008-2009 crisis, but it would certainly rattle the markets,” Rossi says. “At some point, Congress needs to deal with this.”

Remembering Lehman

Back in September of 2008, worries about Fannie Mae and Freddie Mac swiftly retreated to the background when a larger worry – Lehman Brothers – erupted.

Just days after Fannie and Freddie were placed in conservatorship, Lehman Brothers filed for bankruptcy, igniting the worst financial crisis in a half-century. “Lehman Brothers was very much the epicenter of the crisis, a poster child for the bad behavior involving mortgage-backed securities,” says Rossi.

The financial services giant had been packaging up “extremely poorly manufactured mortgages” and selling them to investors around the world, as had several of its peers. The loans, often issued to borrowers who lacked basic income qualifications or collateral, went bad, one after another, as borrowers defaulted.

When Lehman declared bankruptcy, it fell to a group of trustees to settle its debts and its many legal complaints. Ten years later, it’s still working on it.

“Everybody had legal challenges against Lehman – big banks, hedge funds, individual investors, you name it,” says Rossi. “Most of the major players who were doing anything were doing it with Lehman.”

After Lehman’s collapse, bankruptcy courts were inundated with a huge pipeline of legal challenges against it. “That’s now down to a trickle,” Rossi says, as the lawsuits wended their way through the legal process, with many settled out of court.

But this is the way it works, he adds, with financial institutions. Consider the Savings & Loan crisis of the 1980s and 1990s. Some of the legal cases against failed S&Ls went on for two decades.

Although the cases against Lehman now have dwindled to “a trickle," they are not on the verge of ending just yet.

“This trickle, it just reminds us of the scale of the damage that was done,” Rossi says. “After 10 years, it’s still there.”

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About the Expert(s)

RossiCliff

Dr. Clifford Rossi is an Executive-in-Residence and Professor of the Practice at the Robert H. Smith School of Business, University of Maryland. Prior to entering academia, Rossi had nearly 25 years' experience in banking and government, having held senior executive roles in risk management at several of the largest financial services companies. His most recent position was Managing Director and Chief Risk Officer for Citigroup's Consumer Lending Group where he was responsible for overseeing the risk of a $300+B global portfolio of mortgage, home equity, student loans and auto loans with 700 employees under his direction. While there he was intimately involved in Citi's TARP and stress test activities. He also served as Chief Credit Officer at Washington Mutual (WaMu) and as Managing Director and Chief Risk Officer at Countrywide Bank.

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