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Fannie and Freddie Bail Out

Posted Wednesday, July 16, 2008

As I have warned for years (since 2002 to be exact), the collapsing housing bubble finally brought Fannie Mae and Freddie Mac to their knees. It is important to be clear about the nature of the problem so that the best solution can be designed.

The markets are not suffering from a "mental recession" to use Senator Gramm's famous phrase. The markets turned sour on Fannie and Freddie because they sit on $5 trillion of mortgage debt, much of which is going bad. In ordinary times, the prime mortgages that are the basis of Fannie and Freddie's portfolios go bad at very low rates. Even when they do default, since the value of the house is typically close to the value of the mortgage, most of the debt will be covered.

Now loans are going bad at very high rates and the loss for many of these homes will be in the neighborhood of 50 percent, since many of the mortgages in former bubble markets will be far underwater. With the mortgage insurers also going underwater, Fannie and Freddie will have to bear the full loss on many of these foreclosures.

Stockholders and lenders were looking ahead, realizing that falling house prices would make matters worse. They knew that the only question was the exact date of collapse. Not wanting to be there for the wreckage, they dumped their stock. This is exactly what financial markets are supposed to do. If the market had been able to show similar foresight in 2003 or 2004, it would have prevented the worst excesses of the bubble.

There are several key issues in the bailout. Will stockholders get a boost from the Treasury? Will the bondholders be left whole? Will the management that drove these mortgage giants into bankruptcy be left in place, with their multi-million dollar salaries?

The answer to all three questions appears to be "yes," with Congress moving as quickly as possible to approve the bailout package. For now the plan appears to be to leave the GSEs largely intact, as though nothing had happened. Interestingly, the Bush administration, which had previously resisted calls to clamp down on speculation in the oil markets, has sought to restrict short-selling of Fannie and Freddie, as well as other troubled financial companies.

The other part of the story is how much money the government is prepared to pump into housing. This will now be an explicitly political decision with the Fed and the Treasury, rather than the financial market, openly determining how much money goes to finance residential housing.

It is far too early to determine the full impact of the collapse of Fannie and Freddie since it is not clear to what extent they will be forced to change their lending practices. For example, will they be required to consider the price-to-rent ratio before they buy a mortgage? If such a rule had been in effect six years ago, it would have prevented most of the rapid expansion of the housing bubble.

How soon will Fannie and Freddie be forced to re-capitalize and under what terms? To what extent will they be allowed to take on new loans in the meantime? The answers to these questions will have a substantial impact on the housing market in the months ahead.

In other items, the high inflation shown in both the import price index and the producer price index are likely to put upward pressure on mortgage interest rates in the future months. Non-oil import prices are up 7.3 percent from June 2007 to June 2008. Over the last three months, they have been rising at a 12.1 percent annual rate. The core finished goods index of the producer price index rose at a 4.2 percent annual rate over the quarter. The core intermediate goods index rose at a 19.3 percent rate over this period. It is only a matter of time until these price increases show up in the consumer price index.
By Dean Baker