If we try to imagine who benefits by the Fannie and Freddie bailout by the Federal Government we could include Wall Street Investors, homeowners, mortgage lenders, foreign investors, politicians, etc. In the few short days since Sunday's announcement we have seen Wall Street soar, mortgage rates tumble, and politicians seizing the opportunity to curry political favor with voters. The only people who seem to lose, and lose big, are the shareholders who have seen their investments in the GSEs wiped out. But, what about the taxpayers who just "volunteered" to guarantee more than $5 trillion worth of outstanding mortgages? This seems to be a "raw deal" for taxpayers - and doesn't that include just about everyone?
William F. Shugart, II, a senior fellow at The Independent Institute and a professor of economics at the University of Mississippi, wrote an article on August 18, well before the bailout was announced, prognosticating the affects of a failure of Fannie and Freddie. For me it put the massive scale of the bailout into perspective.
In a worst-case scenario, the two companies would be taken over by the federal government. Taxpayers would then be fully responsible for their combined $5.2 trillion in debt, instantly increasing the national debt by 50 percent.
Many have tried to predict the actual cost to the taxpayers, but the truth is nobody knows... yet. The best estimate I have seen is "roughly $200 billion," which appeared on The Atlanta Journal Constitution.
In the very near future, you and I as taxpayers will guarantee the principal and interest payments to the bondholders. You and I will stand behind what the New York Times referred to as “huge potential liabilities” that could cost the taxpayers “tens of billions of dollars.” How much could we be on the hook for? If we assume a 4 percent net loss on a loan portfolio of $5.2 trillion in Fannie and Freddie mortgages during the government’s watch, the taxpayers would conservatively be on the hook for roughly $200 billion.
Clearly something had to be done, and perhaps this take-over by the government was the best of a set of bad options. But, this bailout doesn't fix the problem - it merely allows it to grow larger and cost the taxpayers more... and more... and more.
The government created the "twin monsters" to create liquidity in the mortgage market - that seems to have come to mean "make lots and lots of cheap money available so that people who really couldn't afford homes could buy one anyway." And, wow... did that ever work! In 1940 the homeownership rate was 43.6% - it peaked in 2004 at 69.2%! The homeownership rate for married couples in 2007 was 83.8%.
The real question here is why was the homeownership rate so much lower in the early 1900's and what really spurred the growth? I don't think it was a lack of available funds to lend - rather it was the perceived risk of lending. Before the secondary mortgage market was created - lenders were more frugal. They actually required that someone be able to repay a loan before they could qualify for a mortgage. I know... just ridiculous, right?
Banks used to loan other people's money that was held on deposit. They charged a little bit more to lend, than they paid to deposit. That is how the bank made a profit. It also created risk - if a borrower defaulted, the bank still owed the depositor. Risk is an important factor that can not be over-emphasized. The risk factor was responsible for sensible lending guidelines. The banks wanted to make sure that their borrowers had a job and could afford the monthly payments. And, they required a substantial down-payment so in the event of a default, they could foreclose and sell the property and not wind up with a huge loss.
That was just unacceptable to our legislators. Homeownership is the American dream, it became a right - not a privilege. People should not be denied their right to own a home simply because some "banker" didn't think he could repay the loan. So.... we had to create "liquidity" in the mortgage market to make more money available, right. Well... not so fast. They didn't create more money, they eliminated the risk.
Finally, the bankers could say "yes" to anyone who could manage to find their way to a local branch - "No credit, no job, no problem!" The secondary mortgage market allowed the bank to make risky loans and sell them to Fannie and Freddie. The bank didn't get the interest differential anymore, but they got something better - origination fees! What a great deal for the banks. They were finally able to make more loans and get all of their money upfront in "fees" instead of "interest." When they needed more money, they packaged up a bunch of loans and sold them so they could start over.
So, where did Fannie and Freddie get their money? They had shareholders, but most of it came from selling bonds. This was similar to the deposits that the banks had used previously. Other people gave their money to Fannie and Freddie at a fixed rate. They were happy to do so because the GSEs were created by the government as quasi-public entities and there was an "implicit" guarantee that gave people the warm and fuzzy feeling that if anything went wrong Uncle Sam would make sure they got paid. As it turns out, they were right.
By shifting the risk of default from the banks to the GSEs, homeownership soared - loans were approved left and right. But, it still wasn't high enough. So we created "interest-only" loans to fool even more people into believing they could buy a home. Still not enough... we invented the "liar's loan," so that anyone who could keep a straight face while applying would qualify. Fannie and Freddie kept right on buying and investors kept lining up to buy the bonds.
But it all came to head over the past few years. Some people actually had the nerve to question the Ponzi scheme and they wanted tighter controls on the GSEs. The GSEs spent millions of dollars on lobbying firms to convince our government that they needed to grow even larger.
That (the government take-over) is an especially painful development for the small lobbying firms and solo consultants who rely on Fannie and Freddie for a large chunk of their income.
A CQ MoneyLine analysis of lobbying records found 40 firms registered to represent the companies in the first half of 2008, and billed the companies a total of $2.7 million during that time. Eight of those firms relied on the contracts for more than a quarter of their overall lobbying revenue.
Between 2003 and 2007, Fannie and Freddie took on nearly $4 trillion in additional debt. The GSEs bought more, and bigger, loans. Meanwhile, housing prices began to decline and borrowers began to default in record numbers. Many of the lenders who were making subprime loans went belly-up and left Fannie and Freddie holding the bag. Over the past year, Fannie and Freddie lost about $15 billion. In the same period, Fannie's stock price went from a high of $68.60 to 73 cents! Freddie's stock went from a high of $65.88 to 49 cents!
So what did we learn from this disaster? That mortgage-backed securities are risky investments? No... of course, not. Apparently, we just learned to find even bigger suckers to scam... the American taxpayers!
According to The Atlanta Journal Constitution article:
Placing a guarantee behind a risk asset creates moral hazards. Why? Because the loan originators do not care if the mortgage holder keeps making their payments since they can sell the mortgage to Fannie and Freddie, who in turn will place a guarantee behind the mortgage. If you remove those financial pledges, banks and investors would treat mortgages as risk assets, not a source of guaranteed revenue.
Instead of propping up Fannie and Freddie with taxpayer funds and guarantees, both firms should be gradually removed from the system, an option which is still open to policy-makers. The free market can supply mortgage capital to people who have the necessary debt-to-income ratios and credit history. The current state of the mortgage and housing markets clearly illustrates the results of placing guarantees behind risk assets. Fannie and Freddie are part of the problem, not part of a solution.
Is abolishing Fannie and Freddie even possible at this point? Continuing this business model is irresponsible. We have a system that clearly doesn't work - it has proven to fail! If it had not been for an artificial boom in the housing market, which was in part created by this faulty system, and an endless supply of "implicitly" (now "explicitly") guaranteed funds, we would have realized this a long time ago. Just like a traditional Ponzi scheme, a system like this can only work as long as it continues to grow. As long as enough money is coming in to cover losses, nobody notices that it's all just a house of cards waiting for a slight breeze.
Some "free-market" organizations and libertarians certainly think privatization of the GSEs makes sense. The Heartland Institute is among them.
An alternative to the options of expanded government power is beginning to garner meaningful attention: privatization. Removing Fannie and Freddie's status as government-sponsored entities would relieve the taxpayers of the present "private profit, public risk" problem. It would force Fannie and Freddie to compete as equals in the secondary mortgage market, rather than as anointed duopolists. It would eliminate the special regulator that oversees the two firms, leaving them open to the market's guidance and justice. Most importantly, it would eliminate the incentive for reckless lending at the two firms, as they would bear the full burden of their decisions going forward.
Gerald P. O'Driscoll, Jr., a senior fellow at the Cato Institute and a former vice president and economic adviser at the Federal Reserve Bank of Dallas, suggested privatization in a Wall Street Journal op-ed.
Whatever the outlines of what will inevitably be a hastily crafted bailout plan, the result must be true privatization. That means no more government lifeline: no Treasury line of credit, no Fed line of credit.
If the government takes an equity stake in the companies as part of a bailout plan, there needs to be a time line to end government ownership. Freddie and Fannie must cease to be "special," and become quite ordinary.
Libertarian candidate, Bob Barr, calls this the "bailout from hell." He also advocates the eventual privitization of Fannie and Freddie.
In the short-term, government has little choice but to provide an explicit but limited loan guarantee, thereby capping the public’s liability, now widely assumed to be without limit. At the same time, Congress must restrict the number and size of loans by Fannie Mae and Freddie Mac and set more substantial capital requirements, while authorizing greater Federal Reserve oversight of their operations. The organizations must begin downsizing their portfolios, reducing their risks, and reestablishing their financial credibility.
However, the ultimate objective must be full privatization—with both organizations turned into private companies, responsible for their loan portfolios, and without access to government guarantees or other forms of support. Government should not be in the business of creating multi-billion dollar enterprises to manipulate markets for the benefit of one group or another—in this case, in order to shave the interest rates for selected home buyers by a quarter or half percent.
The idea of privatization is even being touted by the McCain campaign.
Republican presidential candidate John McCain wants mortgage finance companies Fannie Mae and Freddie Mac to eventually be privatized, his chief economic adviser said on Sunday.
"In future the long-term reforms are to scale down Fannie and Freddie so their size is no longer a threat. And then privatize them. Get them off the taxpayer's books entirely," McCain's chief economic adviser, Douglas Holtz-Eakin, told Reuters.
This take-over by the government is only a sound decision if it is the first step toward privatization. But, I doubt that is the course we are on. Henry Paulson, the Secretary of the U.S. Treasury, has been trying for some time to gain more control over the GSE's. He is power-hungry; and, now that he finally has it, he isn't going to be eager to give it up.
Fannie and Freddie bonds have always had that "implicit" guarantee, so I do believe that the government had to do something. But, perhaps it should have sold off Fannie and Freddie assets and liabilities to the private sector with a guarantee to the bond-holders. The government must protect the bond-holders to prevent a global catastrophe. Unfortunately, pumping more money into Fannie and Freddie, with an explicit guarantee to new bond-holders, is only going to make this a bigger problem that we will have to deal with later.
After the take-over, mortgage rates fell by about half a percent. Why? Because you and I, and everyone else in the country, are now co-signing every mortgage. This move does nothing to "stabilize" the market - it only allows business to continue as usual - with no risk to investors. Unfortunately, that risk is an integral part of a truly stable mortgage market. Without it, sensible underwriting guidelines are secondary to churning fee-generating mortgages.
The take-over is good for the financial sector who can continue to sell mortgages without fear and generate fees. That is a boon to the stock market. Investors who buy mortgage-backed securities can continue to throw money into risky investments with no consequences for "bad mortgages." Homeowners can continue to borrow money at low(er) rates. And, our politicians can continue to propose new legislation to ease the burden on struggling borrowers in an election year. You see... this is good for everyone... except taxpayers - and that is just about everyone.
Robert A. Franco
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