Time to Say Goodbye to the Old American Mortgage Pie?

Summary

The news that Treasury Secretary Paulson and Fed Chairman Bernanke are trying to reassure the broader markets that Fannie Mae (FNM) and Freddie Mac (FRE) will not be allowed to fail has not produced the expected calming effect on the markets. Shares of both firms have plunged into single digits. Who would have thought that FNM and FRE would become disastrous ticker symbols whose survival is now being debated? The full faith and credit of the US government is being tossed out as a lifeline, if necessary. Whom would such a lifeline rescue? What will happen to mortgage products, origination – packaging – servicing business models, and the overall housing market?

Analysis

The headlines are starting to sound like obituaries for Fannie Mae and Freddie Mac. What else can happen in this mortgage – credit shakeout.

1. It is safe to say that Federal regulators, the US Congress, and key market participants, particularly fixed income investors, believe that Fannie Mae and Freddie Mac are too big to fail. But, what constitutes failing? Chances are pretty good that it means eliminating FNM and FRE stockholder equity, but conserving the business and maintaining operations as much as possible.

2. Fixed income investors must believe that owning/holding both FNM and FRE debt and their mortgage backed securities (MBS) will be supported by the US government. If not, there will be a run on FNM and FRE debt and the MBS market will crater, dragging down institutions on a global basis. Mark to market for the MBS instruments will be brutal, pushing perhaps many institutions over the edge into failure.

3. The impact of removing Fannie Mae and Freddie Mac overnight as the biggest funding conduits in the mortgage market would crush mortgage loan origination volumes, causing significant damage to the US housing market. Therefore, expect regulators to do what is necessary to keep FNM and FRE operating as close to normal as possible.

4. The fact that FNM and FRE have a doubtful future should be causing every mortgage market player to go into a business disaster recovery planning mode - strategic alternatives that will work are needed.

5. Lending institutions that operate on thin net interest margins will suffer and fade, one way (sell out) or the other (fail). Profitable portfolio lenders with strong market shares face better odds than most.