by hilzoy
The news about Fannie Mae and Freddie Mac sounds terrifying to me:
“Shares of Fannie Mae and Freddie Mac, the beleaguered mortgage finance companies, plummeted again on Friday morning, as senior Bush administration officials consider a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen, according to people briefed about the plan.
Fannie Mae stock was down 36 percent in early trading compared with Thursday’s closing price; Freddie Mac stock was down 41 percent.”
And that was after big previous losses. As of right now, Freddie Mac is down over 87% from a year ago; Fannie Mae is down over 85%.
The FT has a nice, short summary of the problem:
“As house prices have fallen and foreclosures have soared across the US, the two institutions have suffered deep losses, which they have tackled by raising more capital. Many observers believe that a collapse of Fannie Mae and Freddie Mac could bring the US mortgage market to a complete standstill, with severe repercussions for the financial sector and the economy as a whole.
Many investors in Fannie Mae and Freddie Mac have come to assume that the government would eventually come to their rescue because of their importance to the system. However, concern has risen recently that contingency plans for a government bail-out might involve wiping out public shareholders to minimise the cost to taxpayers, while confidence that senior debt would be protected has held up.”
Bringing “the US mortgage market to a complete standstill” does not sound like a very good idea. What are the alternatives? One is a conservatorship:
“Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.”
The shares that would be wiped out presently amount to about $18billion. But the liabilities we, the taxpayers, might have to assume are staggering:
“What Americans need to know is how damaging such a failure would be. This wouldn’t merely be a matter of the Federal Reserve guaranteeing $29 billion in dodgy mortgage paper, a la Bear Stearns. Fannie and Freddie are among the largest financial companies in the world. Their liabilities – mortgage-backed securities (MBSs) and other debt – add up to some $5 trillion.
To put that in perspective, consider that total U.S. federal debt is about $9.5 trillion, compared to a total U.S. GDP of $14 trillion. About $5.3 trillion of that debt is held by the public (in the form of Treasury bonds and the like), while $4.2 trillion is intragovernment debt such as Social Security IOUs. This is the liability side of America’s federal balance sheet, and its condition influences how much the government can borrow and at what rates.
The liabilities of Fan and Fred are currently not on this U.S. balance sheet. But one danger is a run on the debt of either company, putting pressure on the Treasury and Federal Reserve to publicly guarantee that debt to prevent a systemic financial collapse. In an instant, what has long been an implicit taxpayer guarantee for both companies would be made explicit – committing American taxpayers to honoring as much as $5 trillion in new liabilities. U.S. debt held by the public would more than double, and the national balance sheet would look very ugly.”
$5 trillion dollars in liabilities is a staggering amount, even when you consider that not all many of the loans we would guarantee would not go bad*, and so we would almost certainly not be on the hook for the entire amount. But if Fannie and Freddie become insolvent, it would beat the alternative, which is, as best I can tell, more or less shutting down the market for mortgages.
***
Which leads me to an important point. Unlike Bear Stearns, Fannie and Freddie really are too big to fail. What this means, as far as I’m concerned, is that we need to take steps to ensure that they won’t fail. This, to me, was one of the huge lessons of the S&L crisis (and, for that matter, of plain common sense): when the government is on the hook when things go bad, the government should take steps to ensure that things don’t.
Mark Thoma quotes Robert Reich:
“Here we have another example of socialized capitalism. The executives of Fannie and Freddie have been among the best paid in all of corporate America. We’re talking tens of millions a year in CEO pay alone. Fannie and Freddie are treated like giant investor-driven entities as long as they’re healthy and their investors and executives are doing well. But when they start to go down the tubes they become public entities with public responsibilities, the rest of us have to bail them out.”
And adds:
“If failure of these firms endangers the broader economy, and hence threatens to impose large costs on people who had nothing to do with creating the problems, then policymakers need to step in and do what they can to prevent a downward economic economic spiral. In addition, they need to change the rules and regulations that allowed the problem to emerge in the first place, and add new rules and regulations as needed to lower the moral hazard worries going forward.”
Exactly.
(NB: it’s worth noting that the housing bill, which the Senate is considering today, would do just this. Better late than never. But it should have been done years ago.)