The American Mind

Because they play a crucial role in the U.S. mortgage market as well worldwide financial markets federal officials decided to help Fannie Mae and Freddie Mac during their time of crisis:

In a dramatic statement released Sunday, the White House and Federal Reserve moved to give the mortgage giants the capital they need to survive the depression in the housing market and turmoil in financial markets that had left them dangling over a cliff.

Of most immediate importance, the Fed’s board of governors voted to open up its emergency discount window to Fannie and Freddie.

In addition, Treasury Secretary Henry Paulson announced that he will seek Congressional authorization to [buy] stock in the two companies and increase the government’s credit line.

At the moment, each company may borrow only $2.25 billion.

In return for the capital, Paulson said that the Bush administration would ask Congress to grant the Fed a “consultative” role in the capital standards of the companies.

The housing rescue package that is nearing final approval by Congress would put in place a strong independent regulator for the companies is slowly moving through Congress. Paulson says he wants a new provision allowing the Fed to work hand-in-hand with the new agency.

Secretary Paulson’s reasons for acting now are two-fold:

Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.

GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure.

The immediate result of Paulson’s actions was reassurance in Freddie’s bond auction today.

Fannie and Freddie are bigger deals than Bear Stearns simply due to their size and pivotal roles they play in the economy. James Saft wrote [via Rod Dreher],

If you consider what the world would look like if they ran into very serious trouble you quickly realize that they are not just too big to fail, but pretty much too everything to fail.

“With the private label market for mortgages still non-functioning (Fannie and Freddie) offer the only liquidity and bid for mortgages in this market, other than bank and thrift balance sheets,” Keefe, Bruyette & Woods analyst Frederick Cannon wrote in a note to clients.

And indeed, thrift and bank balance sheets aren’t what they used to be, impaired as they are by their own losses on everything from structured finance to leveraged loans to housing related debt.

Before people scream about an unfair bailout realize Fannie and Freddie own or guarantee $5.2 trillion in U.S. mortgages. A collapse along with bankruptcy proceedings would seize mortgage markets preventing new lending–even to worthy borrowers. That would drive housing prices further down, making it harder to get out of our economic rut. Also realize Fannie’s and Freddie’s stockholders have taken a significant hits. The markets have punished them for bad business practices.

I am not thrilled with this development. It’s what happens when you let a public-private partnership run amok and play by its own set of rules. The Wall Street Journal editorial page has been telling the public about Fannie’s and Freddie’s problems for years. They even compared Fannie to Enron.

We’re stuck in a situation that’s the result of years of bad policies. Fannie and Freddie were created without adequate transparency or corporate governance. When Washington politicians of both parties declared home ownership to be an unalloyed good Fannie and Freddie were there to finance “the American Dream.” The Federal Reserve did its part by creating too much money. That money had to go somewhere. Through securitization Wall Street and mortgage lenders funded the great housing boom of the aughts. As with any bubble supply eventually outweighs demand and adjustments have to be made. Housing prices popped bringing on mortgage defaults and foreclosures. Now, we’re dealing with the mess.