Sunday, September 7, 2008

An accident waiting to happen...Mac and Mae

Ok. So Fannie and Freddie are in conservatorship. That does not mean AL Gore is using them to protect the environment.

Backed into the corner conservatorship seemingly keeps options open
This is a move that keeps open the possibility of taking them back private, but how you ever would do that, I will never know. It is a move made by a lame duck president late in this term so come January who knows what the next president will do. But taking them back private hardly seems an option.

Moral Hazard It's Not...
So why not? Apparently the move to conservatorship will wipe out common stockholder value. Some moral hazard eh? The fate of the preferred shareholders is unclear. Bond holders are (as they were with Bear Stearns) 'bailed out.' But these bonds were backed with the full faith and credit of the US government from the very start, weren't they? Wouldn't it have been immoral not to back them after that promise? True the credit lines for Fannie and Freddie were small. But the pledge was large. Too many foreign central banks have bought agency paper as Treasury substitutes. There is no moral hazard here. And there is instead moral obligation to stand by your word - cue Tammy Wynette...

Why F&F were accidents waiting to happen...
or...why you can't get there from here:
Any time you start a business based on below market interest rates like this and let it grow you are nurturing an entity that is dependent on the kindness of government. This was not seed money that was then rescinded, paid back, or held in place. This was a promise of full faith and credit that clung to each and every bond issue as F&F got larger. What else could happen but to find that when you wanted more private capital and were talking of full privatization no bidders -no new capital- would show? Pull the credit line and guarantee, and no one else can raise below market money to maintain the profitability. Indeed, without the Federal backstop F&F leverage is just too great and would not be allowable in the private sector. So more capital with higher costs would just spell a lower return on equity. Who would do that? If lending spreads widened to accommodate a greater rate of return, then the whole purpose of the agencies would be undermined. In short, keeping them public is really the only option that makes any sense. As to truly private: you can't get there from here.

The Cost..if any, yes, IF ANY
We are going to be inundated with estimates of the ultimate cost of this thing. But look at this in a different way. Shareholder capital will take the first losses. After that the government is buying long term assets at a time their value is depressed. If the government can't invest for the long term who can? In time the value of the mortgage portfolio should rise, the economy will recover, house prices will stabilize and advance and at that time if the government wants to liquidate, the cost should be small. There could even be a profit. But there will likely be some cash infusions required before then that will be termed a cost, but that characterization may prove false. Remember in the S&L crisis of the 1980s the government was so eager to dispose of troubled banks it sold many portfolios of seized institutions for penny's on the dollar and took losses into the RTC that it probably did not need to, had it waited. This time since the government has been in the mortgage business all along as a silent partner, providing the full faith and credit guarantee that delivered low borrowing rates, it should be willing to hold these assets a bit longer. After all the Fed is doing that very thing for JP Morgan-Chase.

The GSE's- a case of policy gone amok
This is a case of policy gone amok. Instead of helping some marginal potential homeowners with finances Fannie and Freddie grew to be the bulk of the US mortgage market. This became a program that took on a life of its own. Banks have long opposed the poaching of business by Fannie and Freddie due to their lower cost structure courtesy of the government backstop. But politics intervened. No party reined them in. As a result the subsidy to the whole of the mortgage market grew. Many taxpayer-homeowners benefited, one reason why having 'them' (us) bear the cost makes some sense.

I do not blame Fannie and Freddie for the mortgage crises though they clearly played roles at various times. The real damage was done by investors that only wanted the house as collateral and dropped traditional income and down payment requirements on home-buyers. Some pea-brained investors could not foresee an end to the rise in home prices. Or worse, large-brained rocket scientists mis-used their math to show it wouldn't matter. The vaporized the losses with the laser guns brains of theirs. It's all really hard to believe since all housing markets always have had their cycles. This was a case of banking imprudence done big time. AND the organizational form of Fannie and Freddie has just left them with too many of these things in their portfolios so now they take lumps with everyone else. But the real problem was their mission, their organizational from as GSE's and their size. The mortgage mess was just an inconvenient truth that made it all less viable and exposed the warts that had been there all along.

Fannie and Freddie could remain public. But if they do, let's hope they are scaled down to size and their mission is targeted to a narrower, more needy audience, once this whole thing blows over...years from now. There is no quick fix. This is not one. But it should help to stabilize markets and give the government the opportunity to use the GSE's to help extract us from this mess. That, of course, means that they will get bigger still, for a while, before they get smaller...if ever.

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