Thursday, August 21, 2008

Blowback from the Treasury's Authority to Bail Out Fannie and Freddie

The Treasury Department received the authority to bail out Fannie Mae and Freddie Mac in the mortgage assistance law signed by President Bush on July 30, 2008. This law gave Treasury the power to lend Fannie and Freddie an unlimited amount of money and to invest in their stock or other securities on whatever terms Treasury thought were appropriate. The idea was that the presence of the bailout authority would reassure investors and the financial markets, and allow Fannie and Freddie to seek new infusions of capital from private sector sources. Assuming private capital could be obtained, no government money would be needed and there would be no risk to the taxpayers.

Just the opposite seems to have happened. The real estate markets continue to decline, because losses from the mortgage crisis get larger every time we turn around. The rates of defaults and foreclosures are still rising, because so many mortgage loans have escalating payments that borrowers can't meet. These ever-increasing loan failures depress the real estate market further, which exacerbates the losses Fannie and Freddie already face. As Fannie and Freddie write off ever larger amounts and announce more quarterly losses, private sector sources of capital become more skittish and the prospect of an actual Treasury bailout looms.

The market believes that any Treasury bailout will squeeze out current Fannie and Freddie shareholders. A squeeze-out makes sense, because stockholders shouldn't be protected at the expense of taxpayers. But the risk of a squeeze-out further discourages potential investors from providing Fannie and Freddie with new capital. Why invest in these loss-laden behemoths only to be squeezed out by the Treasury Department a short while later? Fannie and Freddie's stock prices have dropped about 60% this week and now trade in the middle single digits. That's the price range that companies approaching bankruptcy often trade in.

Thus, the mere existence of Treasury's bailout authority discourages investors from infusing Fannie and Freddie with new capital. That, in turn, makes government bailouts essentially inevitable. Treasury probably knows this, but may well hope to delay the bailouts until after the presidential election. Lots of luck. Fannie and Freddie reportedly have to roll over some $225 billion in debt in September. Just two days ago, Freddie had trouble placing some $3 billion in 5-year notes, paying an unusually high interest rate. How will Fan and Fred refi $225 billion in September given the current state of affairs? A Treasury bailout may have to be done soon. Real soon. Maybe Treasury will offer Fan and Fred a Labor Day weekend special rate on new capital. Perhaps the end result will be their nationalization.

That wouldn't be a bad thing if it's handled properly. They're close to nationalized anyway, and someone's got to staunch the bleeding at these gray elephants. But the people running Fannie and Freddie have proven in abundance that they are not up to the job of properly intermediating the mortgage markets. Fannie and Freddie should be eased out of the business of buying new mortgages, and gradually liquidated. The Fannie/Freddie model--private profit with the risk of loss socialized--must be taken to Boot Hill.

One or more new agencies should be created to replace Fannie and Freddie. This time, let's make the government guarantee explicit, as it is with Ginnie Mae, the one mortgage intermediator who doesn't seem to be in trouble. That's because Ginnie Mae maintains high standards for the quality of mortgages it buys. If the taxpayer exposure is explicit, the management of the new agencies will have to be responsible about how they go about doing things. And, as for those mortgages that are too risky for government purchase, there's always the private sector. This time, with no implicit government guarantee to do a fan dance for investors, private mortgage intermediators, who will be expected by investors to keep some skin in the game, will insist on sound underwriting of mortgages. Perhaps then the mortgage markets will actually begin to behave rationally, and real estate values will solidify instead of imitating a fallen souffle.

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