The Corner

Mortgage Giants Down Again

Surprising how little talk there has been around here about Fannie Mae and Freddie Mac, whose shares this morning are down to about $10 and $6, respectively.

The WSJ’s editors put it in perpective yesterday:

Investors are saying that a Bear Stearns-like run on the companies is a real possibility, and they’re right…. What Americans need to know is how damaging such a failure would be. This wouldn’t merely be a matter of the Federal Reserve guaranteeing $29 billion in dodgy mortgage paper, a la Bear Stearns. Fannie and Freddie are among the largest financial companies in the world. Their liabilities – mortgage-backed securities (MBSs) and other debt – add up to some $5 trillion.

To put that in perspective, consider that total U.S. federal debt is about $9.5 trillion, compared to a total U.S. GDP of $14 trillion. About $5.3 trillion of that debt is held by the public (in the form of Treasury bonds and the like), while $4.2 trillion is intragovernment debt such as Social Security IOUs. This is the liability side of America’s federal balance sheet, and its condition influences how much the government can borrow and at what rates.

The liabilities of Fan and Fred are currently not on this U.S. balance sheet. But one danger is a run on the debt of either company, putting pressure on the Treasury and Federal Reserve to publicly guarantee that debt to prevent a systemic financial collapse. In an instant, what has long been an implicit taxpayer guarantee for both companies would be made explicit – committing American taxpayers to honoring as much as $5 trillion in new liabilities. U.S. debt held by the public would more than double, and the national balance sheet would look very ugly.

The companies have a stronger liquidity position than Bear, but investors are saying the chance of a collapse is greater than our politicians want to admit. With its share price decline this week, Fannie Mae’s market capitalization is down to $15 billion. Yet at the end of the first quarter, the company had $42.7 billion in capital. Investors are saying that as a business Fannie is worth only slightly more than one-third of its capital cushion. Fannie’s debt is also priced at the highest spreads over Treasurys since 2000 – another sign of eroding confidence.

Freddie’s market discount from its capital cushion is even worse. Its shares fell nearly 24% yesterday [ME: that was Wednesday, they are down even further since] – to a market cap of some $6.8 billion. Yet its capital, at the end of the first quarter, was $38.3 billion. The message from markets is that both companies are in danger of exhausting their capital and becoming insolvent if home prices keep falling and mortgage losses mount.

ME:  It’s remarkable that even as this public/private debacle is unfolding, we have candidates arguing that the solution to this and that problem is even more government intrusiveness into what used to be private activity.  It’s also remarkable how under the radar-screen this looming disaster still is.  I wonder if that would be the case if most of those principally presiding over it had been Republicans.  Without even mentioning former Carter and Clinton administration big-wig Harold Raines (who took “early retirement” from Fannie while its immense accounting irregularities were under investigation), the Journal continues:

Why is there so little Washington or Wall Street alarm about this? Because the politicians and financiers are part of the consensus that has long promoted the growth of Fannie and Freddie. Congress created the companies to spur home ownership and, in return, got an endless stream of campaign contributions and election support. Beltway elites like James Johnson and Jamie Gorelick made tens of millions working there. Wall Street marketed their MBSs to buyers around the world, pitching them as virtually as safe as Treasurys (due to the implicit taxpayer guarantee) but with a higher return. Everybody made a bundle.

The assumption was that the taxpayer guarantee would never have to be honored, just as everyone before the savings and loan debacle thought deposit insurance would rarely have to be paid. But these political bills always come due.

The double irony amid the current credit crunch is that our politicians have been promoting Fannie and Freddie as mortgage saviors even as their risk of insolvency has grown. Chuck Schumer, Chris Dodd and many others have encouraged the duo to take on even greater mortgage risk as the housing slump has unfolded. They’re the arsonists posing as firemen while putting more dry tinder around the blaze.

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