Sunday, July 13, 2008

A Fair Bailout for Fannie and Freddie: Create a New Mortgage Agency

The Bush administration is once again winging its way through a financial crisis, this time trying to keep Fannie Mae and Freddie Mac on their feet. The Fed has announced that it's given the Federal Reserve Bank of New York the authority to make loans to Fannie and Freddie. The Treasury Department has announced a plan to seek authorization from Congress to increase the credit line Fannie and Freddie have with the Treasury Department (currently at $2.25 billion, lunch money in today's mortgage markets), give Treasury the authority to make equity investments in Fannie and Freddie, and give the Fed greater regulatory authority over Fannie and Freddie.

These proposals look like more rubber bands and chewing gum. The Treasury Department plan is just a proposal. Treasury currently has no authority to do anything except lend Fannie and Freddie $2.25 billion, which may be enough to keep them going for a day or two. The Fed's loan authorization is a tad misleading. It says that the loans will be collateralized by "U.S. government and federal agency securities." How much in the way of U.S. Treasury bills and notes do we think Fannie and Freddie hold? Not much, we'd guess. But if Fannie and Freddie submit agency securities as collateral to the Fed, those securities could be obligations of Fannie and Freddie (which are among the biggest issuers of agency securities). In other words, such collateral would be impaired in value, just like Fannie and Freddie. That's a great deal for Fannie and Freddie, but the taxpayers may be getting yet another stick in the eye from the bailout boys of the Bush administration.

The Fed's loan authority may be enough to keep Fannie and Freddie afloat for the near term. But that would likely be at the expense of more socializing risk while privatizing rewards for wealthy people.

The Treasury Department's plan is aimed at working with Fannie and Freddie as they now exist. That seems more expedient than sensible. Fannie and Freddie's financial conditions remain unclear years after accounting scandals left them unable for a number of quarters to report their financial condition. They've also sent hundreds of billions of dollars worth (or more) of mortgages into special purpose entities, investment vehicles that for accounting purposes are supposed to be separate from Fannie and Freddie. But these vehicles are cousins of the SIVs and conduits that bedeviled banks, and which some banks eventually had to bring onto their balance sheets at great cost. Will Fannie and Freddie have to take on some undisclosed liabilities from these special purpose entities? If so, how many billions are we talking about?

The truth is that Fannie and Freddie are pigs in a poke. The taxpayers shouldn't have to bail them out or prop them up any more than absolutely necessary to prevent a collapse of the financial system. But Fannie's and Freddie's shareholders should have to take their lumps (taxpayers shouldn't protect the value of private equity investments). And Fannie's and Freddie's creditors should have to assume the credit risk that can fairly be laid on them for lending to such severely undercapitalized and mismanaged institutions. In other words, they should take their fair share of losses.

The people who really deserve a bailout here are America's future homeowners, the ones that Fannie and Freddie are supposed to be helping. If they have to borrow through mortgages bought by Fannie or Freddie, the interest rate they'd pay would be elevated because creditors would demand greater returns on account of Fannie's and Freddie's past miscalculations, shenanigans and mismanagement. Why should a young family, starting out, in Indiana, Mississippi or Oregon, have to pay higher interest rates because Fannie or Freddie messed up?

The best thing for the future would be a new mortgage agency, one that starts with a clean slate: new management, prudential lending standards, clean accounting process, no undisclosed liabilities from special purpose entities overhanging the picture, and no loss of credibility with investors. Fannie and Freddie have botched things up badly, and in a free enterprise system, those who botch things up should pay the price. Of course, this proposal is just a pipe dream. If anyone in Congress or the administration actually seriously pushed this idea, Fannie and Freddie would roll out their lobbying juggernauts and quash any attempt to give taxpayers and new homeowners a square deal. After all, in Washington, insiders always win.

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