Socializing losses and privatizing profits is not the way free market capitalism is supposed to work, and yet that's what the country faces thanks to the government's now explicit guarantee of Fannie Mae and Freddie Mac, the too-big-to-fail monsters that have run amuck and now guarantee half of the $12 trillion mortgage market. William Poole, a fellow at the Cato Institute and CEO of the Federal Reserve Bank of St. Louis from 1998 to 2008, calls this situation "distasteful." Others are calling it a whole lot worse.
Given the two companies' precarious states, and the damage to the U.S. and global economies should they actually fail, the politically expedient solution to create a backstop for the GSEs made sense. With Treasury Secretary Henry Paulson its champion, the mortgage bill passed in July expands the $2.25 billion lines of credit the firms have with the Treasury, allows the Treasury to take an equity stake in the entities, and gives the Fed a "consultative" role to work with the firms' new regulator to ensure safety and soundness.
Maybe this short-term fix will work, but second quarter earnings results from both GSEs were not encouraging. Losses continued to mount, at triple the rate Wall Street had predicted. And it's possible those losses would have been quite a bit worse had the companies not resorted to some aggressive accounting, which included counting deferred tax assets (tax-deductible losses carried forward from prior periods that companies can use to offset future tax bills) to make capital calculations.
It's highly unlikely Fannie and Freddie can grow their way out of this problem, and it's not going away; all those failing mortgages will not suddenly begin to perform. Here's a possible scenario: Losses continues to mount, preventing the GSEs from raising desperately needed capital, their finances become shakier, the Treasury does buy some equity, but it soon becomes painfully clear the government is propping up these private companies. The next step is receivership, and that would be a good thing.
People's major concern with receivership is the national debt will double to $10 trillion. But officials have plainly stated the government will not permit default, and so the market already views the implied U.S. debt as $10 trillion. Increasing yields on Treasuries indicate this. Receivership would just formalize an acknowledged reality. It's true that receivership would wipe out shareholders, but that's the risk of equity ownership and the result of bad management. U.S. taxpayers should not subsidize the risk of private enterprises. What's good enough for Bear Stearns investors is good enough for those of Fannie and Freddie.
What then? A slow unwind of Fannie and Freddie would be ideal, then break them into even smaller companies, and sell them off, divorced from any government guarantee, free to compete freely. It can't be done too quickly in today's environment, but it could be done. Poole of the Cato Institute thinks it would take five to 10 years, and given the magnitude of today's muddle it's hard to imagine a timeline much less than the low end of his estimate.
Most proponents of breaking up the GSEs envision, in essence, lots of little Fannies and Freddies being sold off. Gibran Nicholas, chair of the CMPS Institute, an organization that certifies mortgage bankers and brokers, suggests a different approach: break up the GSEs along functional lines. Thus, you might have a firm that owns and develops automated underwriting technology, another specializing in securitization, another focused on commercial financing, and yet another devoted to community outreach.
GSE defenders say their size brings liquidity to the market, makes homeownership possible for many, and reduces its cost. There was some truth to this in 1938 when Roosevelt created Fannie Mae, less so in 1970 when the government chartered Freddie Mac, and virtually no truth to this line of reasoning today. Globalization and the profusion of financial competitors ensures, at least in normal times, a highly liquid marketplace. "When they were created the financial marketplace was much less sophisticated," says Nicholas. Today the GSEs' presence and government guarantee distorts the market and discourages competition.
As for the argument that the GSEs presence makes homes more affordable, it's specious. According to the Federal Reserve, studies have show about half of the implicit taxpayer subsidy for Fannie and Freddie is pocketed by shareholders and management. The other half reduces mortgages by a paltry seven basis points. It was probably never a good deal for taxpayers, and now that they're on the hook for $5 trillion it looks abysmal indeed.
So, even if the short-term fix engineered by Paulson at Treasury works, Fannie and Freddie are not only too big to fail, they're too big to leave alone in their current form. A long-term solution that involves shrinking these institutions and severing their ties to the U.S. government is desperately needed, or this debacle will surely be visited upon us again. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.americanbanker.com/usb.html/ http://www.sourcemedia.com/