Fannie and Freddie rescue means American dream will become a nightmare

September 8th, 2008

Yesterday’s decision by the US Treasury to renationalise the secondary mortgage giants Fannie Mae and  Freddie Mac, which between them guarantee a staggering mortgage liability of $5 trillion, was 100% predictable.

However distasteful, it had to be done. If the two “government-sponsored enterprises” had been allowed to fail, it could easily have precipitated a global financial meltdown.

Placing the disaster-prone mortgage players into the curious quasi-nationalised state of “conservatorship” was probably the least worst option for the lame duck government of George W Bush.

However, the move has many negative connotations. These include:-

(1) It means the United States of America is now, technically speaking, bankrupt. Given the country’s broader geopolitical failures, a country which served as an inspiration to at least half the world from 1945 until 2001, now appears to be destined to a long-term future of increasingly impoverished isolation.

(2) The move suggests that US-style capitalism, previously held up as an example that developing nations ought to follow, is deeply flawed. It confirms that, while the profits from business and finance get privatised, with board directors and shareholders monopolising most of the gains, the losses are invariably socialised. Won’t ordinary taxpayers cotton onto the gross unfairness of this?

Whilst the move, led by US Treasury secretary and former Goldman Sachs CEO Hank Paulson, is unlikely to precipitate an immediate Marxist revolution in the “Land of the free”, the fact of the matter is that US citizens are increasingly going to have to get used to living in a state of bondage.

Effectively, the Yanks have been living beyond their means, both at a government and a personal level, for most of the six decades since World War Two. The Fannie and Freddie bail out only reinforces the harsh reality that it is current and future generations of Americans who will have to pick up the tap for the greed, self-interest and stupidity of their forebears.

(3) Given that it now appaers that no government anywhere in the world is prepared to allow any financial institution to go bust, however flawed its business plan or idiotic its management, we’re facing a future of extreme “moral hazard.”

I am pasting below a leader comment from tomorrow’s Financial Times which puts the renationalisation of Freddie Mac and Fannie May into perspective. To read the article on the FT.com site, click here.

There was no alternative. This weekend, the US government effectively nationalised Fannie Mae and Freddie Mac. It was the right decision. It will save the world from a financial catastrophe, and it means that the absurd quasi-private structure of Fannie and Freddie can now be put to bed, at long last.

Fannie Mae was founded during the Great Depression to buy up mortgages from banks, package them and sell them on to investors. This new agency – then an entirely public body – absorbed the risk of homeowners defaulting while investors took on interest rate risks. Fannie Mae was an ingenious device for making homebuying finance available in desperate times.

It survived in this form until 1968, when Lyndon Johnson, then the US president, turned Fannie into a “government-sponsored enterprise”. Fannie – and its new rival set up in 1970 to provide competition, Freddie Mac – were now owned by private shareholders. Still armed with a “mission” to spread affordable mortgage finance, however, the two GSEs were assumed to have implicit Treasury guarantees.

Since that change, Fannie and Freddie have been exploiting this assumed public backing for their shareholders’ benefit. When Franklin Raines took over Fannie Mae in 1999, he set an objective of doubling earnings per share. This is not quite what Franklin Roosevelt had in mind when he founded it in 1938.

The two GSEs became increasingly aggressive, took unnecessary risks and ran close to – and, on occasion, beyond – their loose regulatory requirements. Their focus on profit left them in bad shape for doing the job government demanded of them: taking on mortgage default risk. The two bodies had more than $5,000bn in mortgages to back but maintained an absurdly slender capital cushion.

In the past year, default rates on US mortgages have more than doubled. With Fannie and Freddie finding it difficult to raise capital to offset their losses, Hank Paulson, the Treasury secretary, sought powers in July to allow him to mount a rescue operation. On Sunday, these powers were triggered and the bodies were put into “conservatorship”.

In addition to taking control of the companies and suspending dividend payments, the Treasury now owns almost 80 per cent of their stock. Mr Paulson has also committed to buying as much extra equity as is needed to make sure the GSEs’ net worth is never negative. Existing shareholders are last in line to claim any residual value in the GSEs and may find their shares are made worthless by the res­cue. They deserve nothing more.

The Treasury, Fannie and Freddie will also invest in mortgage-backed securities to make sure there is sufficient support for US homebuyers. The Treasury has the authority to buy them until the end of 2009. The GSEs will increase their existing portfolios until 2010, when they hope to start paring them back.

Along with a new secured credit facility for the GSEs, the cost of this bail-out might run into hundreds of billions of dollars. Expensive, yes. But not excessive. Allowing the GSEs to fail was never realistic.

Fannie and Freddie’s debts are of systemic importance. They are widely held by foreign investors and central banks, and if the GSEs had been allowed to default there would have been a meltdown that would have threatened the credibility of the US government.

A collapse would also have led to a US housing market crisis. With the value of homes in free-fall, the GSEs backed more than four-fifths of recent US mortgages.

In the long run, the Treasury must have two objectives. It must stabilise house prices at a new, lower level and must not get into the game of trying to maintain ever-rising property values. As soon as it has managed that, the Treasury should devise plans for splitting up and privatising the GSEs. As in other countries, the secondary mortgage market ought to have no public participants. This is a distant prospect – a decade at least – but planning should start now.

After the Bear Sterns and GSE rescues, it is hard to escape the conclusion that all large US institutions offer the security of Treasury bonds but with above-Treasury returns. This is no less true in other developed economies, as the rescue of Northern Roc in the UK demonstrated. Who believes that the German or Japanese governments would allow one of their own leading banks to fail? This is a disturbing prospect.

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Posted by Ian Fraser on Sep 8 2008. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry