On Freddie and Fannie.

[randomness]

What's lost in all the handwringing over Freddie Mac and Fannie Mae was that from the start they were entities created for the express political purpose of manipulating the housing market. They exist in order to promote what later became called "the ownership society", as a way to fight socialism. Putting more people into houses as owners means more people who have a stake in the defense of private property and of capitalism. Arguably, this was quite effective.

However, it cost money. Now, the bill is coming due. Who pays the bill--and how they pay it--those are the real issues, not why and how the money was spent. They spent the money fighting socialism.

It's therefore rather ironic that rather than see Freddie and Fannie fail, a self-described conservative government has decided ideology be damned. The government must take these outfits over lest they collapse and take down the housing market and the credit market with them, rather than let the market sort everything out, as their ideology would have it.

Of course they're trying very hard to obfuscate all this, rather than have people ask the awkward question of why the fight against socialism, and those who gained from it, should be bailed out by socialism.

Do I think we should prevent a collapse? Yes. Spending some money to engineer a graceful outcome and avoid a chaotic crash is worthwhile. Do I think the taxpayer should be the one to pay for that graceful outcome? No.

We'll see who ends up paying the bill.

Comments

[hawver.livejournal.com]

Who do you propose to foot the bill if not the government? Also, I find the idea of fighting socialism through socialism to be kind silly. Even so, if we take that to be part of their mission, it just makes their failure even more complete.

Mission 1 - Affordable housing. Fail.
Mission 2 - Fight socialism. Fail.

[r-ness.livejournal.com]

>Who do you propose to foot the bill if not the government?

I think, at the very least, holders of common stock should be wiped out. The current plan has their share diluted, but not wiped out. I heard an interview with James Lockhart (director of the FHFA, now the conservator of both Freddie and Fannie) in which he was asked what should happen to the holders of common stock. He said (this is a paraphrase from memory) they bought the stock knowing the risk.

I also think the holders of preferred stock should probably take a much larger haircut than they appear to be getting. Initial reports said there was some question as to how much of a loss they would end up taking, partly because there's concern that many banks hold preferred stock in both GSEs, and too much of a loss might cause those banks to fail. Again, my feeling is that they knew the risk, or should have.

The current management is being sacked, but they're walking away on some fairly generous terms. I would revisit that, where legally possible.

That leaves the bondholders, and the Treasury. In an ideal world, where the housing and credit markets stabilize, it might be possible to leave both whole. I don't think we live in an ideal world, but I'm prepared to wait and see.

Also, I find the idea of fighting socialism through socialism to be kind silly.

I put it that way to highlight the silliness, yes.

it just makes their failure even more complete.

Indeed. There is much fail about, and there's more on the way.

[evilmagnus]

They knew the risk.

Well, that's the thing. There was a great deal of nudge-nudge, wink-wink about FNE and FRE ... they were backed by the government, and couldn't be allowed to fail. Yes, the Treasury and others repeatedly said there was no guarantee, but everyone knew there was. Lots of moral hazard there.

[cerebralpaladin.livejournal.com]

I basically agree with your belief that the common shareholders should be wiped out and the preferred should take a big haircut before the gov't (i.e. the rest of us) lose anything... but I'm not sure that isn't what happened as a practical matter. They're stopping all dividends to the common and preferred and the gov't's infusion of money is in the form of purchasing "super senior preferred." If the super senior preferred gets paid its dividends regularly, and the price is reasonable (which I don't know), then the gov't doesn't actually lose any money-- in fact, it gets a profit off the deal. So if Fannie or Freddie gets back to the point where the preferred are getting paid, let alone the common, then the gov't is fine (and the warrants for 80% of the common stock let the gov't claim even more of the profit).

If, on the other hand, Fannie and Freddie lose money after the gov't's infusion of capital, even with the presumably lower bond spread, then the gov't takes a haircut, but the preferred and common shareholders never see another dividend. Sure, they can cut their losses by selling for the option value of their shares-- in that sense they're not wiped out-- but that's pennies on the dollar.

Besides, I'm a little concerned about the idea of the government unilaterally declaring that not currently insolvent companies are not healthy financially, so it's going to nationalize them without the shareholders receiving anything. Maybe this makes sense in the context of GSEs because of their special status, but it still worries me. If these were normal companies, even normal companies too big to fail (Chrysler in the late 70s early 80s?), I would think that the shareholders would have the right to struggle on until they actually failed, not to have the government say "we think you're going down so we're going to intervene."

Anyway, I'm hardly an expert, and maybe I'm wrong that the shareholders will be fully wiped if the gov't takes any real losses-- there could be details I don't understand. But this seems like a pretty good outcome, and there's at least a meaningful chance that by bringing the spreads down (we've basically said "yes, Agency debt is the same as Treasuries"), this will restore them to profitability and result in the gov't making money off of the deal, as odd as that seems.

[digitalemur.livejournal.com]

Aren't Fannie and Freddie going to continue to lose money for a while because the largest number of adjustable rate mortgage resets will happen in Q4 of this year and Q1 of next year, so we're going to see the foreclosure numbers rise for a while longer before it gets better?

[cerebralpaladin.livejournal.com]

So, here is my understanding of what's going on. Fannie and Freddie have exposure on huge amounts of loans-- mind-bogglingly huge amounts, actually. Freddie alone has a total loan portfolio of $2.2 trillion. Now, those loans are assets, not liabilities-- they are entitled to get paid as the homeowners pay off their mortgages. But there are countervailing liabilities-- they pay for the loans they buy by selling bonds ("Agency bonds", because they are GSEs), and they have an obligation to pay back those bonds. Also, much of their portfolio is not directly retained, but sold subject to a guarantee. They sell the future income from a mortgage as a Mortgage Backed Security, but they promise that even if the homeowner defaults, they will pay the purchaser, in exchange for a fee for that guarantee (essentially, this is like selling a financial asset and simultaneously selling insurance on its value-- as long as its value stays there, you get the insurance premia, but if it doesn't, you have to pay out).

So, as loans become delinquent, Fannie and Freddie lose money-- they have to keep paying on their bonds, and they have to pay out on their guarantees on loans that they have sold. The current state of the housing market is very bad, so they've taken big losses, and there are more on the way. In particular, drops in property value are what really hits them. ARM resets contribute to that, but if your payment goes up and you can't afford to pay the mortgage anymore, but you still have net equity in your house, you don't get foreclosed on-- instead, you sell, pay off the mortgage, pocket the difference, and still probably curse the evil bank that sold you the mortgage in the first place. The real problem is when people have gone negative, because of small or nonexistant downpayments (or negative amortization loans) combined with large drops in property values. Then, people actually default, and the bank can't make its money back through a foreclosure sale.

All that said, one of their major expenses is the amount of money they need to spend on interest on the bonds that they issue. Their interest rate has traditionally been only a smidgen above the US government's interest rate on its Treasury bonds. Recently, that spread has increased dramatically. Now, it should drop to 0 or essentially 0-- Agency debt is as good as Treasuries. That means that Fannie and Freddie will have to spend much less money to get their capital, which should mean that they will lose less/make more money. It should also help unclog the mortgage market, which should help make the declines in house values lower (not make them stop altogether, but make the bleeding less bad). So the best case scenario is that, taken as a whole and bearing in mind the fact that both GSEs still had net positive balance sheets before the bail-out, they can now make money again by borrowing at a very low rate, lending at a higher rate, and having enough cushion there to absorb the losses on foreclosed mortgages as part of the cost of doing business (which is what happens in normal times). If they lose money next year and the year after, then return to profitability without an infusion of new capital and make all their payments to the government on its preferred, then at the end of the day the government ends up ahead, even though it lost money in the meantime. So while they may (likely will) lose more money, it may not be as bad as all that, especially now that their costs are so much lower.

In the worst case scenario, the government has to keep pouring money in as they lose money, but then I think the common and preferred shareholders will never see another dime, so that's something. At least it holds down on the moral hazard.

[cerebralpaladin.livejournal.com]

I was curious, so I looked up what Fannie Mae's total mortgage portfolio (retained plus guaranteed) is. Turns out that it's just north of $3 trillion. The $5 trillion or so that they are both involved in is really just unbelievably huge.

This is also why it's really important that the GSE's not default. They have trillions of dollars of outstanding debt and obligations that could totally send many other banks that own their debt or rely on their guarantees into insolvency, as well as really, really pissing off the central banks and such that own lots of the remainder of their debt.

[cerebralpaladin.livejournal.com]

Cut from my last comment for length:
(Also, bear in mind that lots of these losses are paper losses-- marking down the value of assets, not because the loans have defaulted, but because you think a higher percentage of them will default in the future. To the extent that you have done your mark-downs right, which is of course not certain, you have already accounted for the losses now that you will actually lose money on next year. If I have 10 mortgages with face values of $100K each, and I write them down to $50K each (taking a $500K loss today) even though they have not yet defaulted, and then 60% of them pay off in full and 40% default in full, I recognize a gain when they pay off of $100K-- the difference between the value I wrote them down to and the amount of money I actually got from them.)

[babasyzygy.livejournal.com]

What bill? We'll just put it on our Chinese Express. Problem solved.

[r-ness.livejournal.com]

Funny you should mention that.

One of the motivations behind the American government making sure bondholders don't lose any money is that the Chinese are major holders of Agency debt. They have been more and more public lately in their concern that they not be left holding the bag when and if those two agencies go bust.

Now, bondholders can be assured that the U. S. Treasury stands behind the commitments Freddie and Fannie made. Which in turn means that the Chinese should continue to be willing to buy American debt (i.e., raise the credit line on our Chinese Express card).

In turn, we will use that additional credit line to buy more Chinese goods! Everyone wins! :)

For now.

[rmd.livejournal.com]

god forbid we interrupt privatizing profits. better socialize those losses!

[r-ness.livejournal.com]

Absolutely! Losses for *everyone*!

[julianyap.livejournal.com]

My particular problem with Fannie and Freddie is that the whole hybrid system seemed to be set up to create perverse incentives, in that (without conservatorship/nationalism) given the implicit promise that the government would not allow them to fail we had a setup whereby the shareholders profited if the company made money and the taxpayers paid if the company lost money. This of course sets up every incentive to take risky moves. So I basically agree with you (and, weirdly, the Economist)-- company should be nationalized (at least for now), shareholders wiped out, preferred shareholders take a big haircut.

[r-ness.livejournal.com]

Agreed.

Paul Krugman says this better than I can. From http://krugman.blogs.nytimes.com/2008/09/08/deprivatization/:

The fact is that Fannie Mae was originally a government agency; it was privatized in 1968, not for any good economic reason, but to move its debt off the federal balance sheet (and Freddie was created 2 years later as a competitor.) Private ownership of Fannie and Freddie never made any real sense, and was always a crisis waiting to happen.

Is it weird that you find yourself agreeing with the Economist? (I mean that as an actual question, not to make a rhetorical point.)

[julianyap.livejournal.com]

No, no, I agree with the Economist about half the time actually, since I'm fairly moderate on many issues. What I thought was weird was that The Economist was advocating nationalization. They've tended to fall into the "Deregulation and the market will solve everything!" school of thought for a while now

[cerebralpaladin.livejournal.com]

There is a whole school of thought (Tyler Cowen posted about this on Marginal Revolution) that basically amounts to: the GSEs were a terrible idea that should never have existed, even in their fully governmental form; but since they exist and their abrupt total failure would devastate the world-wide economy, deprivatization is the best way out of a bad mess. It seems to be pretty popular among economically savvy libertarians.