Heads I Win; Tails You Lose. The Fannie and Freddie Saga.

Henry Paulson made the right choice. Actually, he made the only choice available. Paulson decided to step in and recapitalize the lending agencies Fannie Mae and Freddy Mac. Failure to do so could have precipitated a total collapse in the U.S. housing market, resulting in a devastating effect on the world economy.

Fannie Mae, the Federal National Mortgage Association, was established in 1938 to provide liquidity to the housing market. Prior to Fannie Mae’s inception the only sources for home loans were community banks and savings and loan associations. These lenders lent at fixed rates but would borrow at variable rates, putting the lenders at risk for the spread. During economic downturns, when liquidity was essential, these lenders could not provide it.

Fannie Mae provided the financing necessary for these lenders to originate the loans, and then transfer the risk to the federal government. In 1968, the government privatized Fannie Mae in order to remove this liability from the federal balance sheet. The government got out of the home loan business, placing government loans under the authority of the newly formed Government National Mortgage Association (Ginnie Mae). Congress established the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970. They created Freddie Mac as a private corporation to provide competition in the home loan market.

Fannie and Freddie benefit from two advantages not available to other lenders: First, there has always been an implied federal guarantee, despite the fact that as a government-sponsored enterprise (GSE) they receive no direct government backing or subsidy. Second, Fannie and Freddie are required to hold less capital (up to 50% less) than other financial institutions. Because of these exclusive advantages, Fannie and Freddie borrow at preferred rates and utilize greater leverage. This creates more profit during good times, but subjects them to greater risk during bad.

The federal government created a situation in which the corporation and its shareholders earned the profits while the federal government assumed the risk. This creates privatization of reward and socialization of risk, the proverbial heads I win, tails you lose situation. That may be a great investment, but it is a poor business model for responsible management.

In addition to profit made on the spread, Fannie earns fees for guaranteeing the credit of the underlying mortgage loans. Investors in Fannie Mae securities were guaranteed payment on interest and principal, unless Fannie Mae went bankrupt. As the impact of the subprime mortgage crisis has become more severe and the downturn in the housing market has expanded, Fannie and Freddie have absorbed the effect of nonperforming loans. The obvious effect is an increase in losses.

In the world of investing, trust is everything. As the fear that Fannie and Freddie were in trouble spread, the price of their stocks plummeted. Concurrently, the cost of their capital increased. As a result, the interest rates offered to perspective homebuyers skyrocketed.

On September 7, 2008 the Federal Housing Finance Agency placed Fannie and Freddie under the conservatorship of the FHFA. Under the reorganization plan, the FHFA has replaced the management and boards of each organization. The FHFA issued new stock to the federal government, diluting the shares of preconservatorship stockholders. The Treasury is expected to invest sufficient funds to meet the liquidity necessary for each institution. For the time being the federal government is back in the home loan business. Anticipating this development, Congress increased the national debt ceiling by $800 billion to $10.7 trillion to provide the Treasury with the necessary means to bail out the two lenders.

The effect of the takeover was immediate. Mortgage interest rates have dropped and the sense of impending doom has lifted, if only temporarily. The extent of the losses remains to be seen. Fannie and Freddie account for half of the outstanding $5 trillion in home mortgage debt. It’s a Catch 22: We don’t want the government in the lending business but if the government doesn’t make good on the guarantees, lenders won’t provide credit, prospective homebuyers won’t get loans and the economy will continue to stagnate. It’s an investment. If markets stabilize and we enter a new growth phase, it is conceivable that the government could make money on the investment. On the other hand, if things fall apart the American taxpayer is on the hook for gigantic losses.

What can we do to avoid this disaster in the future? We can recognize that the idea that open markets are completely efficient and that unregulated commerce will somehow provide the answers to every social and economic scenario is a fantasy. There is a time for regulation and a time to let the market do its thing. We don’t allow child or slave labor in spite of the economic advantage it provides in the marketplace. We don’t want manufacturers to pollute the environment with toxic byproducts however much it may enhance their quarterly bottom line. We don’t want to create an economic environment that privatizes profits and socializes risk.

I imagine we will see the federal government get out of the mortgage business as soon as it is economically viable. That is a good idea in my opinion. There are advantages in keeping the lenders as government-sponsored enterprises. There are good reasons to take them private. In either case, reserve requirements will be more robust and there will be greater regulatory oversight.

Government exists whenever people in society come together to solve common problems and achieve common goals. It exists from the neighborhood block party planning committee to township, county, state, and federal levels. Government at any level can be efficient and effective, or it can be the opposite.

Hank Paulson made an efficient, effective decision. I am sure this federal bailout goes against his political and business sensibilities, but this time it was essential. Hopefully, we will all learn from this and find the right balance between federal oversight and private enterprise.

© 2008 Mike Ryan. Reprinted with permission.

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