Industry takes wait-and-see position

As the financial industry continues to roil with increasing credit and asset issues, the consequences from one of the first government actions – the conservatorships of government-sponsored entities Fannie Mae and Freddie Mac – are largely yet to be seen.

Local mortgage and banking industry veterans are taking a “wait-and-see” position, as each new failure and bailout continues to shape the future of the sector. On Sept. 7, the ongoing string of government actions to stabilize the financial markets began with the Federal Housing Finance Agency placing both Fannie Mae and Freddie Mac into convservatorship.

The agency detailed a four-step plan to secure the nation’s financial and housing markets:

• The entities will increase their mortgage-backed securities holdings through the end of 2009, with an eye toward reducing the cost of funding and promoting stability. Starting in 2010, the portfolios will be reduced by 10 percent per year until they reach a “lower, less risky size.”

• Under the terms of a “Preferred Stock Purchase Agreement” the U.S. Treasury will ensure the companies maintain a positive net worth in return for senior preferred equity shares and warrants. The agreement also establishes a new priority for shareholders, making common and then preferred shareholders first in absorbing the losses.

• The Treasury’s new secured lending credit facility for Fannie, Freddie and the Federal Home Loan Banks will serve as “an ultimate liquidity backstop.”

• A temporary program by the Treasury will purchase mortgage-backed securities to keep mortgage interest rates down.

The immediate impacts of the conservatorships are already being felt, with many positive implications for consumers.

“The interest rates immediately dropped,´ said Jim Hunter, senior vice president and retail production manager for Fort Collins-based First National Bank. Both Fannie and Freddie had factored in a three-eighths to one-half point in pricing to compensate for losses.

“When the government stepped in and stabilized Fannie and Freddie, it gave that back to the market,” Hunter theorized. “Despite the drop, consumers are still leery of doing things now, but our phones did start ringing. Most of the calls have been inquires to see exactly what is happening and what it means for the consumers.”

As for what the conservatorships mean for the industry, it might be too soon to tell.

“That’s a good question – no one knows,” Hunter said. “It will definitely have a lasting impact on the industry,” he said.

Hunter acknowledged that the way business is done in the mortgage industry will change, but everyone will have to wait and see exactly how that will look. A lot depends on how the entities are run, especially in light of a new administration.

Rates could go higher

Even though the immediate reaction was a rate drop, the conservatorships could become an issue in the long term due to the inflationary effect of committing government funds to cover what could become greater losses. Eventually, interest rates could be pushed higher due to rising inflation.

“It all depends on how the oversight shakes out,´ said Doug Braden, broker with Northern Colorado Mortgage Co. and president of the Colorado Association of Mortgage Brokers. He feels that the conservatorships are shaping up as a positive for consumers, but how they will impact small and medium-sized businesses is yet to be seen.

“We’re still in flux right now,” he said. “We have to see how they will handle the government-sponsored entities.”

The conservatorships have also had an immediate impact in the banking industry. Many banks held securities in Fannie and Freddie. Depending on the type of holding, conservatorship stands to be a very positive thing.

Banks hold U.S. government obligations, including mortgage-backed securities, as a regular part of business.

“That’s really what the Treasury was looking to protect,´ said Mark Bower, Home State Bank. Bankers have said that while the security of these holdings has not been set in stone, it has been implied. Where banks take a loss is in preferred and common stock. Bower said that Home State held a small amount of preferred shares that the bank will write down as an unrealized loss, for now.

“We made a lot more money on the day of the conservatorships than we lost,” he said. Because the spread between the U.S. Treasury notes and the mortgage-backed securities tightened, suddenly the mortgage-backed securities were worth more money. Bower said it is too early to forecast what the conservatorships and other financial market actions will have on the banking industry – especially on community banks.

The federal banking regulators issued a statement on the day the conservatorships were announced regarding the banking industry exposure indicating that “a limited number of smaller institutions have holdings that are significant compared to their capital.” Wells Fargo immediately announced it would take a $480 million non-cash charge related to its preferred shares in Freddie and Fannie.

Bower feels the real question is what will happen in 2010 when the government scales down the Freddie and Fannie portfolios – who will step in to fill the market vacancy.

“They are a huge part of the market today,” he said.

One possibility is that the lending will go back to commercial banks, as it was once upon a time. He feels that a major reason for the current mess is that traditional banking activities were suddenly bypassing the banking system.

Lax regulation to blame

Colorado State University economics professor Ronnie Phillips agrees that many of the current financial market turmoil can be traced back to dissolution of certain regulatory safeguards.

“People have forgotten about the Gramm-Leach-Bliley Act of 1999,” he said. The act repealed portions of the Depression Era Glass-Steagall Act. In addition to creating the Federal Deposit Insurance Corp., the act prohibited a bank from offering investment, commercial banking and insurance services.

“People said at the time if you let them do this and don’t adequately regulate them, they’re going to get in trouble,” Phillips said.

It’s all investment banks that are in trouble, it’s not the commercial banks.

A 2004 book, “Too Big to Fail,” contained essays on several U.S. institutions that were careening towards disaster. One was dedicated to Freddie and Fannie.

“The whole problem is (regulators) were letting Fannie and Freddie get very large, and they didn’t care that much about how much risk they were accumulating,” Phillips said. “The regulators and Congress weren’t doing anything about it.”

He feels that the government made the best move possible by taking control of the GSEs. The only other option to avert danger was to privatize them, he explained. With its asset issues and little net worth, privatization became a non-issue.

“I don’t know if it’s sunk in yet, but they’ve nationalized Fannie and Freddie,” Phillips said.

But this is not the first time that the government has owned parts of or the whole financial industry. Phillips points out that in 1935, the federal government had ownership in 50 percent of the banks in the country through its Reconstruction Finance Corp. In fact, about one-third of the total bank capital was owned by the RFC. As the banking industry recovered from the Great Depression, the shares were sold back to the private sector.

“The government is doing what it did in the 1930s,” Phillips said. “The good new is it worked in the 1930s.

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