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| Discussants: | Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance Sebastian Mallaby, Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics Brad W. Setser, Fellow for Geoeconomics Amity Shlaes, Senior Fellow for Economic History |
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September 9, 2008
On September 7, the U.S. Treasury announced it would take control of Fannie Mae and Freddie Mac, the beleaguered U.S. mortgage-lending behemoths. The move marked the largest such takeover in the United States in decades. In the week preceding the Treasury's announcement, the situation for Fannie and Freddie had become increasingly dire. Analysts say the collapse of one of the institutions could have meant massive collateral damage for the U.S. financial system, potentially leading to failures among banks heavily invested in mortgage-backed securities.
Below, four fellows from CFR's Center for Geoeconomic Studies discuss the merits of the Treasury's move, what it is likely to mean for financial markets, and what problems remain.
Roger M. Kubarych
The nationalization of Fannie and Freddie will not hurt the U.S. government's credit rating a bit -- neither did RTC [the Resolution Trust Corporation, a government-owned asset management firm charged with taking on and liquidating the assets of insolvent savings and loan institutions in the 1980s].
The role of F&F in the mortgage market will remain uncertain during the transition, so the housing market situation will not benefit much. Prices are still falling. Foreclosures are still rising. Existing home sales are up mainly because of purchases of foreclosed properties at deep discounts. The Bush administration is not implementing the foreclosure amelioration bill with any sense of urgency. To be sure, some prospective sellers will relax, maybe even take their homes off the market, on the view that the mortgage market won't weaken further. But there is that nasty reality of a 6.1 percent unemployment rate, and the negative impact that will have on the demand side.
What this action shows is:
1) Foreign investors were selling off existing holdings of F&F paper and were increasingly reluctant to buy new paper, so failed F&F issues were highly probable.
2) F&F accounting remained opaque and possibly wrong. They both had much less capital than stated, possibly negative in the case of Freddie.
3) Washington cares little or nothing about the U.S. government's deficit or about inflation.
4) The Fed will be urged to ease monetary policy further to contribute to a rising stock market and improved confidence in the weeks to come.
Will this help the financial markets stabilize? Not entirely: For example, the conservatorship has triggered a determination by the credit default swap dealers that a "credit event" has occurred. That opens the process of arranging an auction (probably messy) for settling CDS [credit default swap] positions. Losers will probably sue, arguing that a credit event shouldn't have been declared.
Sebastian Mallaby
The government's bail out of Fannie and Freddie has delivered a windfall to undeserving bondholders, who had lent money to these housing finance giants on the correct presumption that tax payers would bail them out. But the bail out was nonetheless necessary. The decline in the value of Fannie and Freddie mortgage loans had wiped out their capital. Private investors were unwilling to provide fresh capital to rebuild these crippled institutions, whose failure would have been impossibly damaging to the nation's economic health.
The key question now is what the government's longer term plan is. Is it content to keep Fannie and Freddie in intensive care during the current mortgage downturn, then release them back onto the streets when the economy recovers? That would be a grave error.
The past year has shown that incentives matter in finance. Investment bankers were paid a lot to take enormous risks, but not penalized quite as much if the risks turned sour: These assymetric rewards go some way to explain the excessive leverage at Bear Stearns and other lenders. But the greatest and most scandalous assymetry existed at Fannie and Freddie. In these public-private partnerships, the privateers pocketed the profits in the good times but the public is now bailing out the institutions in the bad ones. Re-privatizing Fannie and Freddie with the same incentives would be inviting history to repeat itself.
The best solution would be to run down the institutions gradually, selling their assets to private companies over a number of years. There's no compelling case for the government to be involved in mortgage finance, so it should aim to exit the sector. It used to be said that government mortgage companies were needed to spread home ownership to low-income households. The subprime story has shown that low income households had plenty of access to home loans—and arguably too much access.
The second best solution would be to break Fannie and Freddie into several smaller institutions and then re-privatize them. If the Baby Fans and Baby Freds were small enough, the implicit guarantee of a government bail-out would be much reduced. It was the sheer size of Fannie and Freddie that compelled the Treasury to come to the rescue this weekend. Such behemonths must not be unleashed again.
Brad W. Setser
Putting Fannie and Freddie into conservatorship should allow them to rollover their debt—and should reassure foreign central banks who have recently been (judging from the Fed's custodial holdings) reducing their holdings of Fannie and Freddie debt. It also—in conjunction with the Treasury's plan to purchase mortgage backed securities guaranteed by the agencies—should allow them to continue to provide credit to the housing sector. Between the end of the second quarter of 2007 and the first quarter of 2008, the Fed flow of funds data indicates that the oustanding stock of GSE bonds and agency and GSE [government sponsored enterprise] guaranteed mortgage pools increased by over $700 billion, making up for a fall in demand for mortgages from private issuers of mortgage backed securities. If the GSEs had to contract their balance sheets now, when there are few other sources of demand for mortgages, the U.S. economy would face a very strong headwind. Fannie and Freddie bonds are also widely held by U.S. financial institutions, so this action helps to protect the U.S. financial system. U.S. commercial banks—according to Fed's flow of funds data—hold as many GSE and agency bonds as foreign central banks. The main effect of the Treasury's action is that it avoids an even worse outcome; it won't end the credit crisis.
Amity Shlaes
The success of the move by the Administration depends on whether the Treasury and White House are able to draw a bright line that says, "no more bailouts after this point." If world markets suspect that the U.S. government has gotten itself in the business of guaranteeing that interest rates on mortgages will not rise in the United States, those markets will turn away from the U.S. Even the U.S. is not large enough to make such guarantees.
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