Fnancial Crysis

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Financial Crisis: "Silver Bullets" for Toxic

Mortgages?

The Obama Administration is floating a proposal that wouldallow the government to directly buy more loans from

servicers of mortgage-backed securities

By David Bogoslaw

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With the financial crisis quickly becoming President Obama's primary burden, hisAdministration has intensified its efforts to stem the rising tide offoreclosures in order to solvethe root cause of the difficulties. On Feb. 11, Treasury Secretary Timothy Geithnerand ShaunDonovan, Secretary of the Housing & Urban Development Dept., met with community groupsand key stakeholders in the banking industry to gauge support for a potential program that would

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allow the government to directly buy whole loans from servicers of mortgage-backed securities(MBS) in order to modify themand keep more borrowers in their homes.

This is just one of several proposals the Obama Administration is considering as it comes toterms with the dire need to prevent further waves of foreclosures amid a deepening recession.

There were foreclosure filings on 274,399 U.S. properties in January, down 10% from Decemberbut 18% higher than a year ago, according to RealtyTrac, a foreclosure research firm. InDecember, the Mortgage Bankers Assn. said that a record 1 in 10 U.S. families with a mortgageare either in arrears or having their house repossessed.

Banks and other mortgage servicers have being doing loan modifications under an FederalDeposit Insurance Corp. program since the first quarter of 2008, but many have failed to benefitfrom a cookie-cutter approach that's paid insufficient attention to the financial condition ofindividual homeowners. And these "mods" haven't addressed the need for a wholesale cleaningout of some of the most toxic loans, those collected in securitized pools and sold piecemeal tovast numbers of investors. The problem is that there is no flexibility to modify the terms of

individual mortgages in most of the Pooling and Servicing Agreements, or PSAs, that governthese mortgage pools.

Employment is Key

At the Feb. 11 meeting with Geithner and Donovan, John Taylor, president and chief executiveof National Community Reinvestment Coalition (NCRC), made the case for loan modificationson a large scale through the Homeowners Emergency Loan Program. This would allow theTreasury to buy distressed loans at big discounts, essentially equivalent to current market value,from the securitized pools. The government would only buy loans of borrowers who still havejobs, but the loans wouldn't necessarily have to be delinquent. For example, they could be loans

whose monthly payments are eating up more that 50% of a homeowner's monthly income andtherefore are at risk of future default.

"That creates the leeway for the government to buy these without any subsidies," says Taylor.That wouldn't even require much taxpayer money from the Troubled Assets Relief Program(TARP) if the government could turn around and sell the loans to banks that have receivedTARP funds, such as Wells Fargo (WFC) and Citigroup (C).

Citigroup declined to comment on whether it would be willing to buy loans from the governmentand modify and service them. The bank, along with JPMorgan Chase, did formally announce onFeb. 13 a moratorium on foreclosures through Mar. 12 in order to allow time for the Obama

Administration to develop a plan to provide relief to struggling homeowners. Those plans areexpected to be released by the end of February. Wells Fargo and Bank of America (BAC), didn'trespond in time for this story to be filed.

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Financial Crisis: "Silver Bullets" for Toxic

Mortgages?

(page 2 of 3)

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Looking to Fannie and Freddie

Banks which end up buying the loans from the government would refinance them and eitherkeep them in their own portfolios, or sell them to Fannie Mae and Freddie Mac to be re-securitized, Taylor adds. "Fannie and Freddie could show the investment community the wayback home to trust mortgage-backed securities again," says Taylor. "When we can show that theAmerican system of finance has returned to some responsible, ethical practices, I think themarket will follow."

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Mortgage loan servicers such as Selene Finance and Ocwen Financial (OCN) agree that the onlyreal solution to the mortgage messand, by extension, the entire financial crisisis to removetoxic loans from the pools and allow banks and other servicers to do modifications in line withwhat the homeowners can afford.

Not so fast, say MBS investors such as William Frey, chief executive of Greenwich Financial.Greenwich filed a lawsuit in December against Bank of America in New York State SupremeCourt, charging that the proposed modification of roughly 400,000 loans originated byCountrywide Financial, which BofA acquired in July 2008, was illegal. Frey says he can affordto pursue the lawsuit only if the court approves all 374 trust contracts the instruments throughwhich investors hold MBSas a class action. He has said that any loans the government wantsto modify that are trapped in securitizations will have to be bought at par, even though that's notequitable given the much lower fair market values of many loans. Otherwise, it will take a longtime for investors to trust mortgage contracts again.

Hard to Track Down MBS Investors

Taylor at NCRC and others argue that even at 70 on the dollar, the investors in securitizedmortgage trusts would be getting more for these loans than the 50 and less on the dollar atwhich some recent sales have been done. But Frey counters that because losses are allocated tothe bottom classes of investors when the loss is finalized after the sale of the loans, the soonerlosses are determined, the sooner the lower rungs of investors stop getting paid. "This wholemorass is actually working to the benefit of some classes. If [servicers] were to expedite thelosses, they'd expedite crystallization of losses," he says. Then servicers would run a greater riskof being sued by those investors, he adds.

Safe harbor legislation that would protect servicers from lawsuits came up in hearings on the

Hope for Homeowners bill that was being marked up in the House Financial Services Committeein early February, says Allan Krinsman, a partner at law firm Stroock & Stroock. "[Committeechairman Representative] Barney Frank (D-Mass.) understands this issue and has indicated he'swilling to give servicers relief. Now it's about convincing the rest of the committee to put it intothe legislation," he says.

It's not that easy to track down individual MBS investors, many of whom hold shares in thesesecurities through their brokerage accounts, in a timely manner, according to Gary Silverstein, apartner in the tax department at Cadwalader Wickersham & Taft LLP. And while some investorsmay be willing to approve the sales, "there could be some investors who will withhold theirconsent to renegotiate a better deal or just out of spite perhaps," he says.

Financial Accounting Modifications Necessary

Karen Bellezza, who heads Selene Finance, which has been modifying non-securitized homeloans since 2007, says the talk in the industry is that trustees aren't reaching out to investors toget their consent for loan mods, partly because they don't even know who to contact.

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Financial Crisis: "Silver Bullets" for Toxic

Mortgages?

(page 3 of 3)

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She says she's convinced that removing these loans from the securitized pools is the only way toget control over them.

Paul Koches, general counsel at Ocwen Financial, believes the key to allowing the governmentto buy whole loans from the trusts that hold them before they default lies in amending FinancialAccounting Standard 140 (FAS 140), which doesn't permit the outright sale of loans pre-foreclosure out of those trusts. "If that could be re-characterized as a loan servicer activity, itwould arguably pass muster under FAS 140 and satisfy the purchase of whole loans" before theydefault, he says. He thinks that clear guidance on that point "would be a silver bullet" to start thecleanup of the financial crisis.

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Making that all the more important is data from the Federal Housing Finance Administration(FHFA) showing that although just 16% of the 55 million outstanding mortgages in this countryare in private label securitized trusts, those mortgages account for about 62% of thedelinquencies, adds Koches.

Motivated to Get the Market Running

Not every single securitization will demand investor consent, but even the ones that don't mayrequire a nod from ratings agencies, which might not be able to act fast enough to approve anyamendments to documentation governing the securitized pools of mortgages, says Silverstein atCadwalader.

The American Securitization Forum, a unit of the Securities Industry & Financial ManagementAssn. that represents MBS servicers and investors, has publicly supported the idea ofgovernment purchases of loans from private-label securities since November 2008.

Given that most people in the securitization industry are suffering, they're as motivated asanyone else to get the market running again, says Silverstein at Cadwalader. But they're resistantto aggressive proposals, such as one that didn't make it into the stimulus bill, that threaten torescind tax-free status from any trusts that fail to agree to any changes the government mayultimately require, he adds.

Other Avenues of Relief

There are other proposed plans by the Treasury and the Federal Reserve in the offing that areintended to provide relief to struggling homeowners, including subsidies for mortgage payments."We need a concrete program with some real rules and structure around it so the industry can

move on," says Bellezza at Selene.

Bogoslaw is a reporter forBusinessWeek's Investing channel.

http://www.businessweek.com/investor/content/feb2009/pi20090216_756983_page_3.htm

Subprime mortgage hedge fund crisis

Main article: 2007 subprime mortgage financial crisisSee also: Subprime lending and Collateralized debt obligation

On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out"one of its funds, the Bear Stearns High-Grade Structured Credit Fund, while negotiating withother banks to loan money against collateral to another fund, the Bear Stearns High-GradeStructured Credit Enhanced Leveraged Fund. Bear Stearns had originally put up just $35 million,so they were hesitant about the bailout, however CEO James Cayne and other senior executivesworried about the damage to the company's reputation.[6][7] The funds were invested in thinlytraded collateralized debt obligations (CDOs).Merrill Lynchseized $850 million worth of theunderlying collateral but only was able to auction $100 million of them. The incident sparked

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concern of contagion as Bear Stearns might be forced to liquidate its CDOs, prompting a mark-down of similar assets in other portfolios.[8][9]Richard A. Marin, a senior executive at BearStearns Asset Management responsible for the two hedge funds, was replaced on June 29 byJeffrey B. Lane, a former Vice Chairman of rival investment bank, Lehman Brothers.[10]

During the week of July 16, 2007, Bear Stearns disclosed that the two subprime hedge funds hadlost nearly all of their value amid a rapid decline in the market for subprime mortgages.

On August 1, 2007, investors in the two funds took action against Bear Stearns and its top boardand risk management managers and officers. The law firms ofJake Zamansky& Associates andRich & Intelisanoboth filed arbitration claims with theNational Association of SecuritiesDealers alleging that Bear Stearns misled investors about its exposure to the funds. This was thefirst legal action made against Bear Stearns, though there have been several others since then.Co-President Warren Spector was asked to resign on August 5, 2007, as a result of an ongoingconflict with Cayne. Spector, considered the apparent heir to become CEO, was blamed byCayne for the failure of the hedge funds. A September 21 report in the New York Times noted

that Bear Stearns posted a 61 percent drop in net profits due to their hedge fund losses.[11]

WithSamuel Molinaro's November 15 revelation that Bear Stearns was writing down a further $1.2billion in mortgage-related securities and would face its first loss in 83 years, Standard & Poor'sdowngraded the company's credit rating from AA to A.[12]

Matthew Tannin and Ralph R. Cioffi, both former managers of hedge funds at Bear StearnsCompanies, were arrested June 19, 2008. They are facing criminal charges and are suspected ofmisleading investors about the risks involved in the subprime market. Tannin and Cioffi havealso been named in lawsuits brought forth by Barclays Bank, who claims they were one of themany investors misled by the executives.[13][14]

They were also named in civil lawsuits brought in 2007 by investors, includingBarclays BankPLC, who claimed they had been misled. Barclays claimed that Bear Stearns knew that certainassets in the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage MasterFund were worth much less than their professed values. The suit claimed that Bear Stearnsmanagers devised "a plan to make more money for themselves and further to use the EnhancedFund as a repository for risky, poor-quality investments." The lawsuit said Bear Stearns toldBarclays that the enhanced fund was up almost 6% through June 2007 when "in reality, theportfolio's asset values were plummeting."[15]

[edit] Fed bailout and sale to JPMorgan Chase

On March 14, 2008, JP Morgan Chase, in conjunction with the Federal Reserve Bank of NewYork, agreed to provide (under terms and conditions to be agreed) a (up to) 28-day emergencyloan to Bear Stearns in order to prevent the potential market crash that would result from BearStearns becoming insolvent.[16]Despite, or because of, this, belief in Bear's ability to repay itsobligations rapidly diminished among counterparties and traders. Seeing that the terms of theemergency loan was not enough to bolster Bear Stearns, and worried that a still-floundering Bearwould result in systemic losses if allowed to open in the markets on the following Monday,Federal Reserve Chairman Ben Bernankeand Treasury SecretaryHenry Paulson Jr.told CEO

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Alan Schwartz that he had to sell the firm over the weekend, in time for the opening of the Asianmarket. [17] Two days later, on March 16, 2008, Bear Stearns signed a merger agreement with JPMorgan Chase in a stock swap worth $2 a share or less than 10 percent of Bear Stearns' marketvalue.[18] This sale price represented a staggering loss as its stock had traded at $172 a share aslate as January 2007, and $93 a share as late as February 2008. In addition, the Federal Reserve

agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase,[19]

thereby assuming therisk of Bear Stearns's less liquid assets (see Maiden Lane LLC). This non-recourse loan meansthat the loan is collateralized by mortgage debt[20] and that the government can not seize J.P.Morgan Chase's assets if the mortgage debt collateral becomes insufficient to repay the loan.[20][21]

Chairman of the Fed, Ben Bernanke, defended the bailout by stating that a Bear Stearns'bankruptcy would have affected the real economy[22] and could have caused a "chaoticunwinding" of investments across the US markets.[18]

On March 20, Securities and Exchange Commission Chairman Christopher Cox said the collapseof Bear Stearns was due to a lack of confidence, not a lack of capital. Cox noted that BearStearns's problems escalated when rumors spread about its liquidity crisis which in turn eroded

investor confidence in the firm. "Notwithstanding that Bear Stearns continued to have highquality collateral to provide as security for borrowings, market counterparties became lesswilling to enter into collateralized funding arrangements with Bear Stearns," said Cox. BearStearns' liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion onMarch 13. Ultimately market rumors about Bear Stearns' difficulties became self-fulfilling, Coxsaid.[23]

On March 24, 2008, a class action lawsuit was filed on behalf of shareholders, challenging theterms of JPMorgans recently announced acquisition of Bear Stearns.[24] That same day, a newagreement was reached that raised JPMorgan Chase's offer to $10 a share, up from the initial $2offer, that meant an offer of $1.2 billion.[25]The revised deal was aimed to quiet upset investors

and any subsequent legal action brought against JP Morgan Chase as a result of the deal as wellas to prevent employees, many of whose past compensation consisted of Bear Stearns stock,from leaving for other firms. The Bear Stearns bailout was seen as an extreme-case scenario, andcontinues to raise significant questions about Fed intervention. On May 29, Bear Stearnsshareholders approved the sale to JPMorgan Chase at the $10-per-share price.[26]

http://en.wikipedia.org/wiki/Bear_Stearns#Subprime_mortgage_hedge_fund_crisis

Federal takeover of Fannie Mae and Freddie

Mac

From Wikipedia, the free encyclopedia

Jump to: navigation,search

Fannie Mae headquarters at 3900 Wisconsin Avenue, NW inWashington, D.C.

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The federal takeover of Fannie Mae and Freddie Mac refers to the placing intoconservatorship ofgovernment sponsored enterprisesFannie Mae and Freddie Macby the U.S.Treasury in September 2008. It was one financial event among many in the ongoing subprimemortgage crisis.

On September 7, 2008, the director of theFederal Housing Finance Agency (FHFA), James B.Lockhart III, announced his decision to place two Government sponsored enterprises (GSEs),Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home LoanMortgage Corporation), into conservatorshiprun by the FHFA.[1][2][3]

At the same press conference, United States Treasury Secretary Henry Paulson, stated thatplacing the two GSEs into conservatorship was a decision he fully supported, and that he advised"that conservatorship was the only form in which I would commit taxpayer money to the GSEs."He further said that "I attribute the need for today's action primarily to the inherent conflict andflawed business model embedded in the GSE structure, and to the ongoing housing correction."[1]

The same day, Federal Reserve Bankchairman Ben Bernanke stated in support: "I stronglyendorse both the decision by FHFA Director Lockhart to place Fannie Mae and Freddie Mac intoconservatorship and the actions taken by Treasury Secretary Paulson to ensure the financialsoundness of those two companies."[4]

The following day, Herbert M. Allison was appointed chief executive of Fannie Mae.He came fromTIAA-CREF, where he fired 500 employees (8 percent of the workforce).[5]

[edit] Background and financial market crisisMain articles: Financial crisis of 20072008and Global financial crisis of 2008

The combined GSE losses of US$14.9 billion and market concerns about their ability to raisecapital and debt threatened to disrupt the U.S. housing financial market. The Treasury committedto invest as much as US$200 billion in preferred stock and extend credit through 2009 to keepthe GSEs solvent and operating. The two GSEs have outstanding more than US$ 5 trillion inmortgage backed securities (MBS) and debt; the debt portion alone is $1.6 trillion.[6] Theconservatorship action has been described as "one of the most sweeping governmentinterventions in private financial markets in decades,"[7] and one that "could turn into the biggest

and costliest government bailout ever of private companies".[8]

With a growing sense of crisis in U.S. financial markets, the conservatorship action andcommitment by the U.S. government to backstop the two GSEs with up to US$ 200 billion inadditional capital turned out to be the first significant event in a tumultuous month among U.S.-based investment banking, financial institutions and federal regulatory bodies. By September 15,2008, the 158 year-old Lehman Brothersholding company filed for bankruptcy with intent toliquidate its assets, leaving its financially sound subsidiaries operational and outside of the

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bankruptcy filing. The collapse is the largest investment bank failure sinceDrexel BurnhamLambert in 1990.[9][10] The 94 year-old Merrill Lynch accepted a purchase offer by Bank ofAmericafor approximately US$ 50 billion, a big drop from a year-earlier market valuation ofabout US$ 100 billion. A credit rating downgrade of the large insurerAmerican InternationalGroup (AIG) led to a September 16, 2008 rescue agreement with the Federal Reserve Bankfor a

US$85 billion dollar secured loan facility, in exchange for a warrants for 79.9% of the equity ofAIG.[11][12][13][14]

[edit] Previous attempts for GSE reform

The GSE business model faces inherent conflicts due its combination of government mission andprivate ownership. According to the American Enterprise Institute, a conservative think-tank:"The government mission required them to keep mortgage interest rates low and to increase theirsupport for affordable housing. Their shareholder ownership, however, required them to fightincreases in their capital requirements and regulation that would raise their costs and reduce theirrisk-taking and profitability. But there were two other parties--Congress and the taxpayers--that

also had a stake in the choices that Fannie and Freddie made. Congress got some benefits in theform of political support from the GSEs' ability to hold down mortgage rates, but it garneredeven more political benefits from GSE support for affordable housing." [15]

In 2003, the Bush Administration sought to create an agency to oversee Fannie Mae and FreddieMac.[16] While Senate and House leaders voiced their intention to bring about the neededlegislation, no reform bills materialized. A Senate reform bill introduced by SenatorJohnCorzine (D-NJ) (S.1656) never made it out of the 21-member (10D/11R) Senate Banking,Housing, and Urban Affairs Committee.[17]. At the time members of the 108th congressexpressed faith in the solvency of Fannie and Freddie. Congressman Barney Frank(D-MA), forexample, described them as "not facing any kind of financial crisis." [18]

In 2005, the Federal Housing Enterprise Regulatory Reform Act, sponsored by SenatorChuckHagel (R-NE) and co-sponsored by Senators Elizabeth Dole (R-NC),John McCain (R-AZ) andJohn Sununu (R-NH)[2], would have increased government oversight of loans given byFannieMaeand Freddie Mac. Like the 2003 bill, it also died in the Senate Banking, Housing, and UrbanAffairs Committee, this time in the 109th Congress. A full and accurate record of thecongressional attempts to regulate the housing GSEs is given in the Congressional recordprepared in 2005. [19][20]

Gerald P. O'Driscoll, the former vice president of the Federal Reserve Bank of Dallas, stated thatFannie Mae and Freddie Mac had become classic examples ofcrony capitalism. Government

backing let Fannie and Freddie dominate the mortgage-underwriting. They returned some of theprofits to the politicians, sometimes directly, as campaign funds, and sometimes as"contributions to favored constituents."[21]

[edit] Federal Housing Finance Agency and Treasury

authority

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The Housing and Economic Recovery Act of 2008passed by the United States CongressonJuly 24, 2008 and signed into law by President George W. Bush on July 30, 2008 enabledexpanded regulatory authority over Fannie Mae and Freddie Mac by the newly establishedFHFA, and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizingFannie Mae, or Freddie Mac, limited only by the amount of debt that the entire federal

government is permitted by law to commit to. The law raised the Treasury's debt ceiling byUS$800 billion, to a total of US$10.7 trillion, in anticipation of the potential need for theTreasury to have the flexibility to support Fannie Mae, Freddie Mac, or theFederal Home LoanBanks.[22][23][24]

[edit] Prior GSE support measures

The September 7 conservatorship was termed by The Economistas the "second" bailout of theGSEs.[25] Prior to the enactment of the Housing and Economic Recovery Act of 2008, on July 13,2008, Treasury Secretary Henry Paulson announced an effort to backstop the GSEs based onprior statutory authority, in coordination with the Federal Reserve Bank. That announcement

occurred after a week in which the market values of shares ofFannie Mae and Freddie Macfellalmost by half (from a previously diminished value of approximately half of year-earlier markethighs).[26] That plan contained three measures: an increase in the line of credit available to theGSEs from the Treasury, so as to provide liquidity; the right for the Treasury to purchase equityin the GSEs, so as to provide capital; and a consultative role for the Federal Reserve in areformed GSE regulatory system.[27] On the same day, the Federal Reserve announced that theFederal Reserve Bank of New Yorkwould have the right to lend to the GSEs as necessary. [28]

[edit] Capital infusion by the Treasury

The agreement the Treasury made with both GSEs specifies that in exchange for future support

and capital investments of up to US$ 100 billion in each GSE, at the inception of theconservatorship, each GSE shall issue to the Treasury US$ 1 billion of seniorpreferred stock,with a 10% coupon, without cost to the Treasury.[6][29]Also each GSE contracted to issuecommon stockwarrants representing an ownership stake of 79.9%, at an exercise price of one-thousandth of a U.S. cent ($ 0.00001) per share, and with a warrant duration of twenty years .[30]

The conservator, FHFA signed the agreements on behalf of the GSAs. [30] The 100 billion amountfor each GSE was chosen to indicate the level of commitment that the U.S. Treasury is willing tomake to keep the financial operations and financial conditions solvent and sustainable for bothGSEs. The agreements were designed to protect the senior and subordinated debt and themortgage backed securities of the GSEs. The GSEs' common stock and existing preferred

shareholders will bear any losses ahead of the government. Among other conditions of theagreement, each GSEs retained mortgage and mortgage backed securities portfolio shall notexceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches$250 billion.[31]

[edit] FHFA initial actions as conservator

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In the September 7, 2008 conservatorship announcement, Lockhart indicated the following itemsin the plan of action for the Federal Housing Finance Agency conservatorship: [2]

1. On September 8, 2008, the first business day of the conservatorship, business will betransacted normally, with stronger backing for the holders ofMortgage Backed Securities

(MBS), senior debt and subordinated debt.[32]

2. The Enterprises will be allowed to grow their guarantee MBS books without limits andcontinue to purchase replacement securities for their portfolios, about $20 billion permonth, without capital constraints.

3. As the conservator, the FHFA will assume the power of the Board and management.

4. The present Chief Executive Officers(CEOs) of both Fannie Mae and Freddie Mac havebeen dismissed but will stay on to help with the transition.

5. Appointed as CEOs are Herbert M. Allison for Fannie Mae and David M. Moffett forFreddie Mac. Allison is former Vice Chairman ofMerrill Lynch and for the last eight

years chairman ofTIAA-CREF. Moffett is the former Vice Chairman and CFO ofUSBancorp. Their compensation will be significantly lower than the outgoing CEOs. Theywill be joined by equally strong non-executive chairmen.

6. Other management action will be very limited. The new CEOs agreed it is important towork with the current management teams and employees to encourage them to stay andto continue to make important improvements to the Enterprises.

7. To conserve over $2 billion annually in capital, the common stock and preferred stockdividends will be eliminated, but the common and all preferred stocks will continue toremain outstanding. Subordinated debt interest and principal payments will continue to bemade.

8. All political activities, including all lobbying, will be halted immediately. Charitableactivities will be reviewed.

9. There will be financing and investing relationship with the U.S. Treasury via threedifferent financing facilities to provide critically needed support to Freddie Mac andFannie Mae, and also to the liquidity of the mortgage market. One of the three facilities isa secured liquidity facility, which will be not only for Fannie Mae and Freddie Mac, butalso for the 12 Federal Home Loan Banks that are regulated by FHFA.

[edit] Government support for Fannie Mae and Freddie Mac

In addition to the government conservatorship, which CBO estimates will increase the federalgovernment's net liabilities by $238 billion, several government agencies have taken steps toincrease liquidity within Fannie Mae and Freddie Mac. Among these steps includes: [33]

1. Federal Reserve purchases of $23 billion in GSE debt (out of a potential $100 billion)and $53 billion in GSE-held mortgage backed securities (out of a potential $500 billion).

2. Federal Reserve purchases of $24 billion in GSE debt.

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3. Treasury Department purchases of $14 billion in GSE stock (out of a potential $200billion).

4. Treasury Department purchases of $71 billion in mortgage backed securities

5. Federal Reserve extension of primary credit rate for loans to the GSEs

[edit]National debt accounting

The on- or off-balance sheet obligations of the two GSEs, which are "independent" corporationsrather than federal agencies, are just over $5 trillion, a significant amount when compared to the$9.5 trillion of officially reported United States public debt at the time of the takeover.[34] TheSeptember 7, 2008 conservatorship and the subsequent planned Treasury infusion of capitalsupport the senior liabilities, subordinated indebtedness, and mortgage guarantees of the twofirms. Some observers see this as an effective nationalization of the companies that ultimatelyplaces taxpayers at risk for all their liabilities.[35] The federal government follows specializedaccounting standards set by the Federal Accounting Standards Advisory Board. The net exposure

to taxpayers is difficult to determine at the time of the takeover and depends on several factors,such as declines in housing prices and losses on mortgage assets in the future. [36] TheCongressional Budget Office directorPeter R. Orszag announced on September 9, 2008 that theCBO intended to incorporate the assets and liabilities of the two companies into their federalbudget planning, due to the degree of government control over the entities.[6][37] The White HouseBudget Director Jim Nussle, on September 12, 2008 indicated their budget plans would notincorporate the GSE debt into the budget because of the temporary nature of the conservatorintervention.[37]

Bloomberg reported that according to CMA Datavision of London that "five-year credit-defaultswap contracts on U.S. government debt increased 3.5basis points on September 9, 2008 to a

record 18, up from 6 basis points in April," in reaction to concerns about the potential rise inU.S. debt from bailouts.[6]

[edit] Market consequences

[edit] Bank reserves

Many commercial banks in the United States own Freddie and Fannie preferred shares. Thoseshares have had their dividends suspended, and are junior to the senior preferred stock issued tothe Treasury in the restructuring of the two companies. The market value of the preferred shares

plunged after the restructuring announcement and suspension of dividends. Banks were requiredto write down the value of Freddie and Fannie preferred stock held in their portfolios,compounding capitalization concerns for certain U.S. banks.[38] Gateway bank agreed to bebought out by Hampton Roads Bankshares Inc. to make up for a writedown of $40 million on itsstock in Fannie and Freddie, which put it below regulatory requirements to be consideredadequately capitalized.[39]

[edit] Credit default swaps

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In the credit default swap (CDS) market, the standard contracts typically used between parties toa swap define the action of placing Fannie Mae and Freddie Mac into conservatorship to beequivalent tobankruptcy, because of the change in management control. In CDS parlance, this istermed a credit event, and that triggers the settling of outstanding contracts for the derivatives,which are used to hedge or speculate on the potential risk that a company will default on its

bonds. The two GSEs have approximately US$ 1.5 trillion in bonds outstanding, and since themarket in credit default swaps is not public, there is no central reporting mechanism to verifyhow many credit default swaps are linked to those bonds. One estimate floated is US$ 500billion, and that the entire CDS market has a notional value in the vicinity of US$ 62 trillion.[40][41] Settlement on the contracts, will likely be the largest in the market's decade-long history. [41]Credit-default swaps on Fannie and Freddie have been among the most actively traded theseveral months leading up to the conservatorship. "Thirteen 'major' dealers of credit-defaultswaps agreed 'unanimously' that the rescue constitutes a credit event triggering payment ordelivery of the companies' bonds," according to a memo circulated by the International Swapsand Derivatives Association(ISDA) after the conservatorship announcement.[42] The day afterthe conservatorship announcement, the International Swaps and Derivatives Association, which

sets industry standardized contracts forfinancial derivatives and swaps, announced it wasworking on a protocol on how to evaluate and settle Fannie Mae and Freddie Mac credit defaultswaps.[43]

Paradoxically (in relation to typical experiences when a company issuing bonds has a "creditevent"), the value of the two GSEs bonds rose to the vicinity of par value after theconservatorship. This means, that some owners of swaps that were hedging against the risk of abond default, may be worse off, since the value of the bonds may be higher than when theypurchased the swap. Cash auctions are reported to be scheduled for October 2008 to settle CDScontracts in relation to the GSEs.[40][44]

[edit] September 2008 reactions to the seizure

The immediate reactions in the finance markets on Monday September 8, the day following theseizure, appeared to indicate satisfaction with at least the short-term implications of theTreasury's intervention. Governor of the Bank of JapanMasaaki Shirakawa stated "We expectthe action would lead to stabilize the U.S. [mortgage-backed securities] market, financial marketand the international financial market." Governor of thePeople's Bank of China, China's centralbank, Zhou Xiaochuan stated "From my point of view this is positive".[45]

[edit] Effects on the subprime mortgage crisis

The effects on the subprime mortgage crisis have led the government to support the soundness ofthe obligations and guarantees on securities issued by Fannie and Freddie to obtain funds. Thosefunds are in turn used to purchase mortgages from originating banks. The continuing soundnessof GSE obligations enhances market liquidity (loanable funds) in the following ways: [46]

Banks can be assured that Fannie and Freddie have funds to purchase conforming loans,so they can increase such lending. This improves liquidity in the mortgage market,lowering interest rates.

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Lower borrowing costs for banks typically increase the "spread" between the rate atwhich they borrow and which they lend. This increases bank profitability, shoring upbank liquidity and balance sheets further.

Adjustable rate mortgage (ARM) rates are reduced, which lowers pressure onhomeowners and reduces foreclosures. Lower rates also encourage new home purchases.

The government's role as the primary investor allows a systematic loan refinancingprocess to be implemented. This should enable rapid loan adjustments or workouts forhomeowners, which have been facing bottlenecks due to the requirement to have variousinvestors approve the adjustments.[47] For example, the government could rapidly push-down 45-year mortgage terms and fixed, low interest rates, enabling many morehomeowners to stay in their homes. This will reduce foreclosures significantly, helping tostabilize home prices.

The government can restructure mortgages so that the loan balance is reduced to thecurrent market value, reducing the incentive for homeowners to "walk away" from the

property. With home prices more stabilized, the value of mortgage-backed securities receives some

upward support.

[edit] Financial condition of Fannie and Freddie prior to

takeover

Over 98 percent of Fannie's loans were paying timely during 2008. [48] Both Fannie and Freddiehad positive net worth as of the date of the takeover, meaning the value of their assets exceeded

their liabilities. However, Fannie's total assets to capital (leverage ratio) was about 20:1, whileFreddie's was about 70:1.[49][50] These numbers increase significantly if one includes all of themortgage-backed assets they guaranteed. These ratios are considerably higher than investmentbanks, which leverage around 30:1.[51][52]

However, there was concern that the GSEs' liquidity was insufficient to handle growingdelinquency rates, such that although viable in September 2008, the scale of loss in the futurewould be sufficient that insolvency would occur and that knowledge of this future failure wouldinduce immediate or near-immedi