Mortgaged to the hilt: DNA: 19th July 2008

The collapse of Fannie Mae and Freddie Mac has vital lessons for India
Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corporation) are the two largest mortgage finance companies in the USA, established respectively in 1938 and 1970. While they are owned by ordinary shareholders, they have the unique backing of the government and are called Government Sponsored Entities (GSEs). This means that they are supported by the Federal Reserve and the government and are entitled to lines of credit and a bailout in case of a crisis. More importantly they are exempted from taxes and outside SEC (Securities Exchange Commission) oversight.
The two firms do not lend directly to home owners. They instead buy mortgages from approved lenders and then sell them on to investors. They guarantee or own roughly half of the $12 trillion US mortgage market. These are the two ways in which they make money. Almost all US mortgage lenders, from huge financial institutions like Citigroup to small, local banks, rely on Fannie Mae and Freddie Mac to keep up their businesses. Lenders look to them for the funds they need to meet consumer demand for home mortgages. By linking mortgage lenders with investors, the two firms keep money available at a low cost. These companies buy mortgages from banks and take on the risks of possible defaults — allowing banks to make even more mortgages.
The sub-prime crisis centred on a housing collapse due to reckless lending encouraged by a benign interest rate regime. When interest rates rose and borrowers faced higher outflows, they began to default. The process of securitisation fostered by these cousins made the process complex as the originators of the loans got mixed up and the final investors lost badly. Fannie Mae and Freddie Mac made losses of around $11 bn in the last three quarters. Further, news spread that they were under-capitalised, meaning they would have to go to the market for capital infusion. But, when an institution is under-capitalised and making losses, no one is willing to invest in their equity. This created the panic.
The implications of a collapse are serious. If these two entities are not able to borrow from the market or can do so only at a high cost, then the market senses trouble and would be wary of lending to those seeking housing loans. Housing has been a major stimulant for the US economy and the present slowdown could be largely attributable to the collapse in this business. This led to the eventual crisis as their share prices tumbled as investors lost confidence in these institutions.
The basic paradox here is that these two GSEs are considered to be too large to fail (we heard that of Enron earlier) and simultaneously considered too large to rescue. Therefore, direct government action was mandatory to retain market confidence. This was done in three ways. First, the Treasury decided to buy a stake in their equity to augment capital. Then, the New York Fed chipped in by providing a line of credit and third was the imposition of a condition where the Fed would henceforth have oversight of their operations.The story of these cousins is pertinent to us because mortgage finance has been gaining in importance in India over the last five years. However the share of these loans in total bank credit is only about 15 per cent. Housing finance companies on their part have been relatively more conservative with their lending operations and are well capitalised.
But the issue is broader. In a rising interest rate scenario, we always run the risk of defaults and the institutions would come under pressure as losses mount when defaults take place. Today the ratio of Non-performing assets to total loans is around 1 per cent in this segment, which is low. Further, the securitisation habit, which transfers risks to other entities and can make the originator a bit callous, has not really caught on as yet. Our public sector banks — GSEs in the US sense — broadly resemble the Freddie-Fannie cousins, but there is a critical difference. Public sector banks are well regulated by the RBI which has imposed prudential lending norms, absent in case of the American counterparts.
The Freddie Mac and Fannie Mae episode sends a warning signal across the world and highlights the importance of regulation in the financial business.Regulation of GSEs becomes more critical because, there could be a tendency for such institutions to slip into somnolence and hence become reckless especially if they are sure that they will be bailed out by the government.