Freddie and Fannie Rescue Package: Caveat Taxpayer
Now that the House has passed a vital rescue package for Freddie Mac and Fannie Mae, and the Senate will take up that package -- in a rare Saturday vote tomorrow morning at 11 a.m. -- there is still time to consider the implications for U.S. taxpayers.
No one would argue that the package should not be enacted, and the president's last-minute decision to rescind his threat to veto it is welcome.
But it is not too late for lawmakers to address the cost to taxpayers of a worst-case scenario - the failure of the package to restore the confidence of private investors in the financial position of Freddie and Fannie and the investors' unwillingness to provide the liquidity to the nation's two largest mortgage finance institutions.
In debates over the last several months, as efforts to reform Freddie and Fannie got started; in the Federal Reserve Bank's cash infusion to stave off the bankruptcy of Bear, Stearns in March; and in the response to the current crisis facing Freddie and Fannie, little heed has been paid to the potential liability facing taxpayers.
In the case of Bear, Stearns, U.S. taxpayers were asked to backstop one $30 billion transaction - and the rescue package now making its way through Congress could put them at far greater risk.
In the worst case, how much could U.S. taxpayers be on the hook for under the package? The Congressional Budget Office (CBO) released a report this week that ventured a guess that, in all probability, the cost to taxpayers would be $25 billion at the end of the day. But CBO Director Peter Orszag added that there was a chance that figure might end up being $100 billion. No one has identified a worst-case figure.
Freddie and Fannie currently hold $5.2 trillion in mortgage loans and guarantees. The riskiest loans, known as the alt-A and subprime mortgages, constitute about 15 percent of that portfolio, worth about $780 billion.
Last week, Treasury Secretary Henry Paulson promised that terms and conditions of the package would "protect the taxpayer," without elaborating.
But the new credit line to be extended to Freddie and Fannie under the package has no dollar limits at all. The proposal also permits the government to purchase equity of Fannie and Freddie. But a provision to insure that the government (read, the taxpayer) would receive preferred stock - that is, payment prior the claims of Freddie and Fannie's shareholders - if Treasury seeks give Freddie and Fannie a cash infusion through an equity purchase, was dropped.
Some in Congress claimed that taxpayer liability was effectively constrained by the statutory debt limit, currently $9.8 trillion. But the rescue package was actually amended to provide for an $800 billion increase in the debt limit, to $10.6 trillion. At least this $800 billion would cover the worst case of a total default of Freddie and Fannie's subprime portfolio. But that cannot be a comforting thought for taxpayers.
Others point to rights conferred in the package for the government to control compensation packages for executives of Freddie and Fannie. But even in the highly unlikely event that such compensation was cut by $10 million, that amount would be fractions of a penny on the dollar for taxpayers.
How, then, can Congress and the administration make good on Paulson's promise to protect taxpayers?
First, the terms and conditions of the credit line for Freddie and Fannie could be made transparent. Second, the provision offering preferred stock to the government should Treasury make a purchase of equity in Freddie and Fannie could be restored. Third, taxpayers could be allowed to share in the gains that Freddie and Fannie make if - we hope when - the package succeeds.
These protections should not be too much to ask. Failure to provide them would continue the unfortunate precedent of the government to capitalize profits and socialize losses when major financial institutions fail. And it would undermine any faith that taxpayers have that the government isn't actually sowing the seeds of future crisis, ignoring moral hazards by coming to the rescue whenever financial giants make bad decisions and face crises.
With all the Brokers that were promising mortgages to people who are desperate for some form of home or security in this world. Didnt you mean Caveat Temptor?
July 25, 2008 7:23 PM | Reply | Permalink
. . . a vital rescue package for Freddie Mac and Fannie Mae . . . No one would argue that the package should not be enacted . . . .
Polly want a cracker?
. . . it is not too late for lawmakers to address . . . .
Pollyanna want a cracker?
July 25, 2008 9:23 PM | Reply | Permalink
Taxpayers have always had a piece of the upside of Fannie and Freddie. Its a healthy thriving leveraged mortgage market that operates better than any other country in channeling liquidity so people can affordably borrow to buy a house.
Fannie and Freddie have always paid for the privileged position they hold. They must be the buyers of last resort. They may not expand internationally or vertically. They are subject to regulation and the political process. They could not function if they did not operate more efficiently than any other participant (even with the high executive salaries, so often mentioned).
If the mortgage market doesn't succumb to a total lack of liquidity, taxpayers are walking away with the bargain end of the stick.
And what on earth suggests that the CBO estimate is anything more than a crude back-of-the-napkin job? I don't know how many discrete scenarios they considered, but $100B cost at a 5% chance worst case scenario probably suggests their "real" zero cost scenario chance at 65%. If history means anything (and the mortgage insurers don't bust) that real change is probably well in excess of 90%.
July 26, 2008 1:10 AM | Reply | Permalink
I take issue with your presumption, there is no equity in Freddie/Fannie, they are insolvent and if the market were allowed to work that would be plainly obvious to a 10 yr old. equity in zero has no value.
And I don't believe bailout is essential to economic health. They should be allowed to fail, it would bring down house prices so those who actually saved money could afford to own one. Fred/Fann simply insures home loan providers, they don't really provide a primary market for anything. I disagree w/ the common thesis of interest rates, they would not get that high, only moderately so which is healthy in the long term sense. Moreover, renting is not akin to being homeless and as we're seen home equity can be illusory(i.e. downurn) and has enabled many to take on stupid levels of personal dent.
There has been a plan to offload the bad derivative debt instruments of the finance industry and dodd/paulson/bernanke and the OFHEO have been executing it for 2 yrs now. Thats why in the last year or so OFHEO has allowed Fannie/Freddie and regional home loans banks to accepts all forms of collateralized debt obligations from Banks and investment houses(for which there was no market as everyone knows said debt was worth at most, 10-30% of stated value)and give them treasury securities in exchange. In doing so, the fed gov has allowed wallstreet to offload a great deal of their bad debt and traded them $1 in value of treasuries for a .20 in value of collateralized negligently underwritten debt. That's a 70% loss given to these GSE's.
Now in phase 2 of bailout the treasury/congress/ofheo has told congress to expand the federal deficit capacity by 1.4 trillion dollars(which is not mentioned in news stories) and the CBO quotes a 25 billion estimate for the bailout, which is a laughable underestimate. The capacity increase for the deficit of 1.4 tril was done to enable fannie/freddie/fhlb's to be bailed out by the the us taxpayer under the guise of supporting the entire american housing injury.
They couldn't sell a direct bailout to the taxpayer of wallstreeters which is why they played this risk transfer hot potato game to get bad debt out of the hands of the rich and into the fed gov't thereby salvaging credibility for the greedy private financial system that was sadly given a steroid injection when the glass stegal act was repealed and the OFHEO in 1992 was created.
Welcome to America
July 26, 2008 10:01 AM | Reply | Permalink
Back of the envelope the U.S, is running a current account deficit of around $800 billion a year.
Foreign central banks are responsible for investing that $800 billion, and given the state of the U.S. economy, they're not prepared to invest those funds in corporate bonds or equities. What's left? U.S. Treasuries and Agencies (F/F debt, etc.).
The annual issuance of Treasuries is equal to the deficit which leaves a $300-400 billion dollar shortfall in Treasuries available for investment. The Agencies are all that is left.
Therefore, unless we're prepared to allow F/F to increase their balance sheets -- issue more debt and use the proceeds to buy mortgages and mortgage backed instruments which, by definition, are going to come from "Banks and investment houses" -- what are the foreign central banks supposed to do with their unwanted dollars?
July 26, 2008 11:35 AM | Reply | Permalink
. . . OFHEO has allowed Fannie/Freddie and regional home loans banks to accepts all forms of collateralized debt obligations from Banks and investment houses . . . and give them treasury securities in exchange.
You say OFHEO has "allowed" F/F to trade structured financial instruments for treasuries.
Have F/F actually traded any? With whom? How much? Would you have any links?
July 26, 2008 10:31 AM | Reply | Permalink
The government buying preferred shares would further hurt Fannie and Freddie's common shareholders. It devalues their stock both by diluting it and putting it a rung behind in terms of asset recovery should a failure occur. Not saying it's a bad idea, but it does have a cost.
July 26, 2008 11:18 AM | Reply | Permalink
Chairman Frank cautioned industry representatives: I would hope that no one would be foreclosed upon between now and October 1st who would have qualified for this program had the effective date been immediate.
You gotta admit Barney Franks is one sneaky ole mensch.
He knows perfectly well that mortgage servicers who are required to pay the unpaid interest to the investors and to pay real estate taxes and property insurance out of their own funds can't afford to wait as they watch their cash go out the door and their balance sheets erode.*
So who's he actually talking to? You should have guessed it -- Fannie and Freddie and the FDIC.
He's telling those govermental(?) organizations "Don't foreclose; the taxpayers will take care of your losses."
* A defaulting mortgage usually goes into "nonaccrual" status after 90 days; before that date servicers pay interest, taxes & insurance; after that date taxes and insurance, only.
July 27, 2008 11:36 PM | Reply | Permalink