Archive for Tuesday, July 15, 2008

U.S. should nationalize Freddie, Fannie

July 15, 2008


Capitalism has triumphed everywhere, but it's time to dust off an old socialist slogan. When it comes to housing finance, the commanding heights of the economy must be nationalized. Sunday night's statement from Treasury Secretary Hank Paulson was designed to look statesmanlike and measured, but it misses an opportunity.

You can understand why nationalization is not Paulson's first choice. Fannie Mae and Freddie Mac, the two monster housing-finance companies, between them owe trillions to their bondholders. Nationalizing that exposure would appear to inflate the federal debt, and there's been talk of damage to the nation's credit rating. Moreover, Fannie and Freddie have made or guaranteed almost half of all loans to American homeowners. Can it be healthy to have the government control that much lending?

Of course not. But nationalization is healthier than the other options.

Injection of money needed

Start with the fact that, despite loud official denials until Sunday night, the government will have to inject money into the mortgage lenders. Intervention may be precipitated soon if Freddie has trouble with its plan to borrow $3 billion in the markets. Even if the lenders escape the bond market equivalent of a bank run, which is what destroyed Bear Stearns, they are likely to succumb to a variant that might be called an "equity run."

Investors know that Fannie and Freddie need to raise fresh capital, diluting existing shareholders. So they have been marking the shares down, which means that, to raise any given sum, Freddie and Fannie must sell an even greater percentage of themselves to new investors. The prospect of a larger dilution drives the stock down further, setting off a vicious cycle: Last week the firms' shares lost nearly half their value. The upshot: Fannie and Freddie can't raise the equity that everyone knows they need.

If public money is going to be injected, the question is how to provide it. For politicians squeamish about nationalization, the easiest course is to have the Fed lend to Fannie and Freddie. The Fed confirmed Sunday night that it stood ready to act, and after all that has happened over the past year, the public would probably accept emergency Fed loans as part of the new normal. But in addition to bailing out private investors and undermining market discipline, a Fed rescue would put taxpayers on the hook with little to no compensatory upside.

If the government is going to risk taxpayers' cash, it should inflict punishment on private players and demand an equity-type payoff. So the issue is whether to become a minority shareholder or, at the other extreme, the sole one.

Paulson made clear Sunday night that he favors a minority stake. But from a purely financial perspective, it would be better to buy the whole caboodle. If the government is going to supply a rescue, why share the upside? The worry about adding to the federal debt turns out to be a digression. Although Fannie and Freddie owe an astronomical amount, they are owed a roughly similar amount. The net effect of nationalization on the federal debt would be modest.

Of course, we wouldn't want the feds buying General Motors even if its assets represented a bargain, because we don't want the government in the car business. But Fannie and Freddie are special. Their murky public/private status is odious.

Unfair advantages

Fannie and Freddie are private, profit-seeking businesses that enjoy unfair advantages: They get regulatory and tax breaks, and they borrow more cheaply than other firms because the government stands behind them. When they grow and do well, they pay their executives lavishly, so the executives are always pushing to expand. But the bigger the lenders get, the larger the threat to taxpayers. And, because their collapse would be catastrophic for the financial system, the larger the threat to the economy.

What do taxpayers get out of this arrangement? Fannie and Freddie used to say they were vital in making mortgages available to low-income households. But the subprime debacle shows that low-income households had too much access to credit, not too little. Fannie and Freddie now say they are vital to keeping the mortgage market operating in hard times. Over the past year this has proven true, but there is a limit to how far Fannie and Freddie can play this role: Witness the collapse of their share prices.

Government should take over

As long as Fannie and Freddie retain their private/public form, private managers will invent reasons to grow courtesy of public assistance. The best shot at taming them is to bring them into the government. Then, once financial markets have stabilized, the government should shrink the institutions radically and spin them off in pieces, creating maximum space in the mortgage market for smaller private players.

The collapse of Fannie and Freddie's share prices presents an opportunity to buy them on the cheap. Rather than rushing to prop up these behemoths, authorities should seize the moment: Nationalize - and then dismantle.

Sebastian Mallaby is a fellow for International Economics with the Council on Foreign Relations.


bondmen 9 years, 11 months ago

The authors statement "Although Fannie and Freddie owe an astronomical amount, they are owed a roughly similar amount. The net effect of nationalization on the federal debt would be modest." is still very much in question. First, what they are owed is the problem, namely debt secured by falling real estate values still in search of a bottom. Second, nationalization implies the largest possible loss as all sorts of broken and valueless things could be thrown in and charged off to US taxpayers.Freddy and Fanny, via their quasi governmental backing, helped to foster the housing bubble in America by supplying liquidity to over inflated (and appraised) housing values and confirming (securitizing) those excessive values in the marketplace. Those who invested in the paper Freddy and Fanny issued received a yield above (more recently, well above) government guaranteed paper of similar maturity. So investors were compensated for the added risk of not owning paper with explicit government backing by the US Treasury.Furthermore "the top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."" These investors should certainly be considered sophisticated and therefore fully aware of the risks associated with purchasing theses securities. Tell me again why should US taxpayers be saddled with bailing them out?Finally Freddy and Fannie were sponsored by Congress to foster RE loan transactions in America by making the loans conform to a uniform set of standards. That's fine, but the implicit (now explicit) government guarantee fostered home ownership at the expense of renters. Renters have been unfairly subsidizing this enterprise all along.

Godot 9 years, 11 months ago

Absolutely. But, Frank, Dodd and Schumer are the ones who have carried the water for Fannie and Freddie and BOA and Countrywide by pumping a "mortgage rescue" bill that is nothing more than a taxpayer bailout for these bad actors.

just_another_bozo_on_this_bus 9 years, 11 months ago

"The members of Congress that have served on the banking and finance committees over the last 15 years (in particular, Barney Brank, Chuck Schumer and Christoper Dodd)"Given that these committees were run by Republicans for 12 of the last 15 years, shouldn't there be a few Republicans on your list, Godot?

Daytrader23 9 years, 11 months ago

Nationalize - and then dismantle.Yeah, right like that will happen. I say let them fall. They got themselves into this mess if they can't get out then by the law of nature and the markets then they deserve to fall and fall hard. Don't worry, someone will come and take their place. It's called creative destruction and it's vital in supporting healthy markets. The markets are sick and we need to get rid of the viruses that are making it sick before it can start to get better again.

jafs 9 years, 11 months ago

I don't really understand why our government needs to "bail out" companies that aren't doing well - free market theory would allow them to fail.If, on the other hand, providing loans (low-interest) to low-income folks is in the public interest, perhaps that should be a public service that the government provides. Without the profit motive, I would imagine they could provide lower interest rates and, unlike corporate bailouts, we would get the money back as people pay off the loans.

Godot 9 years, 11 months ago

Absolutely not. Freddie and Fannie need to go belly up. Congress has been incompetent, maybe even maliciously negligent, in its duty to regulate and supervise this private/government entity. Fannie and Freddie have donated hundreds of thousands, if not millions, of campaign dollars to the members of the committees charged with its oversight. The members of Congress that have served on the banking and finance committees over the last 15 years (in particular, Barney Brank, Chuck Schumer and Christoper Dodd) should be investigated by a special investigator for their unsavory and cozy relationships with the financial institutions there were supposed to regulate.

just_another_bozo_on_this_bus 9 years, 11 months ago

This will go the way of all the other corporate bailouts-- obscene profits are privatized, obscene losses are socialized (ie, passed along to the taxpayers.)

Satirical 9 years, 11 months ago

I completely agree, we should socialize Fanny and Freddie because the banking industry is essential to our country, and we dont want to kick people out of their homes. Then we can socialize medical care, bececause it's all about the"we." Then the government should take over those greedy oil companies because oil is so important, and let's face it profit is a bad thing. After that the government should socialize the airline industry because it is doing so poorly and we just can't have a few airlines fail. These are all great liberal ideas, because capitalism is bad with all those winners and losers, and we only want winners (the only loser is the people).

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