Fannie Mae and Freddie Mac to Get Two Major Lifelines

This touched off a new, more ferocious wave of selling of financial-sector stocks that has been going on for many weeks. However, this process entered a very unstable and dangerous phase after the failure of IndyMac, Inc., one of the largest mortgage lenders in the country. Collateral selling hit the stocks of Fannie Mae and Freddie Mac, and that process intensified as a former senior Federal Reserve official declared in a public statement that Fannie Mae and Freddie Mac were insolvent, while both the treasury secretary and the Fed chairman were making public testimony denying support for the "too-big-to-fail" doctrine.

The speculative wave of selling of government-sponsored enterprise stocks threatened the GSEs' ability to conduct funding in the debt markets, with about $3 billion in funding at risk on the morning of July 14. Spreads on GSE debt had already moved back up to crisis levels in the past two weeks, with further upward pressure on retail mortgage rates in the pipeline. The impaired ability of the GSEs to fund themselves in the debt markets—given the critical role that the GSEs now play in terms of providing liquidity for the mortgage markets—is the final straw that broke the camel's back, thereby forcing the Federal Reserve and the Bush administration to take the emergency measures that were announced on the weekend.

Access to the Fed's discount rate facility is a maneuver that will effectively defuse the short-term liquidity crisis that has erupted in terms of the GSEs' ability to fund their operations. The GSEs now have access to very low-cost borrowing from the Fed's discount window, at 2.25%. While the Fed opened up the discount window to primary dealers back in March, the utilization of the window by the dealers has declined substantially in the past two months, so there is plenty of capacity for the Fed to lend under the discount facility. Indeed, the Fed is providing unlimited access to the discount window by the GSEs.

The Treasury also announced unspecified infusions of equity capital to the GSEs. At this point, this is a critical additional policy measure that is needed to insure their viability as private entities, as the recent deterioration of the housing market, combined with further pressures on the financial system from rating downgrades and capital write-offs, has essentially foreclosed the ability of the GSEs to raise new capital. Substantial capital infusions are now necessary from the Treasury. Several months ago, the GSEs were given general guidance by Congress and the Office of Federal Housing Enterprise Oversight to raise in the range of $8–12 billion each under their new regulatory regime. The Treasury needs to announce a substantial capital infusion program quickly to defuse the capitalization crisis and reverse further speculative selling of Fannie Mae and Freddie Mac stock. This would probably need to be at least $20 billion (perhaps in the form of preferred stock), phased in over perhaps several quarters.

This crisis of liquidity and capitalization of the GSEs is an unfortunate and potentially dangerous turn of events in the current U.S. business cycle. It must be defused swiftly and effectively, because failure to do so would risk a further meltdown of the housing and mortgage markets of proportions not seen since the Depression era. This is not the time for policy makers to underestimate, once again, the systemic risks to the financial system and the huge collateral damage this would impose on the economy. Bold, creative, and aggressive financial policy action is needed—and it is needed now.