10.01.2008 0

Full Faith and Credit?

  • On: 10/19/2008 01:45:46
  • In: Economy
  • “No less than the international perception of the credit quality of the U.S. government is at stake.”—Richard Hoffmann, Credit Sights.

    Between the sub-prime mortgage failure of 2007, the recent turmoil of Fannie Mae and Freddie Mac, and the failure of Indy Mac, it is clear to all observers that the U.S. financial system is hurting. Badly. So much so, that the big mortgage bailout has finally been agreed to by both political parties, which includes a contingency rescue plan in case the mortgage giants, Fannie and Freddie, keep assuming losses.

    Fannie Mae and Freddie Mac, Government Sponsored Enterprises (GSE’s), actually may exceed the dictum “too big to fail.” Combined, they oversee about half of all U.S. mortgages. Their collapse would signal, generally speaking, an end to the current U.S. housing market (such as it is). And the risk they pose economically exceeds even that: about 20 percent of the mortgage-backed securities issued by the mortgage giants—about $1.5 trillion worth—are owned by foreign investors. In short, should these GSE’s actually fail, the U.S. and global financial system would be dealt a catastrophe on an order never seen.

    To make matters even worse yet, those securities were sold by the GSE’s with the guarantee that if anything went wrong, the U.S. government would be there to back up the companies. Should the GSE’s fail to recapitalize, there would be nothing to stop the owners of those securities from dumping them in a rush to get their money back before the GSE’s went under. That would deal a critical blow to American property owners.

    So, somebody’s on the hook now that everything has gone very wrong: as usual, the U.S. taxpayer.

    The Congressional Budget Office recently put a cost estimate on a Federal government bailout of Fannie and Freddie at $25 billion. If this number seems too small to be true, that’s because it is.

    According to the same cost estimate issued by the CBO, as of March 2008, on a fair-value basis the GSE’s owned about $1.607 trillion in assets and had about $1.6 trillion in liabilities. The CBO therefore puts their net financial position at $7 billion as of March. Also, “they are required to hold only a fraction of what is mandated for commercial banks as a financial cushion against risk…” under a 1992 law. The GSE’s own about $780 billion in the riskiest loans: sub-prime and Alt-A loans.

    That all left the GSE’s with a truly small margin for error just a few months ago, which is why when fears arose this month that the government would have to bail out the GSE’s, it became a self-fulfilling prophecy. Whether it was justified or not, the prospect of a bailout spooked investors, leaving the mortgage giants with a desperate need to raise capital.

    So, the potential of failure was greater for these GSE’s by design. And the impact of such a failure was magnified by their sheer girth all in the name of making housing more “affordable”—even as home values reached record values in the past 20 years as cheap money flooded the market. That created an artificial demand that could not be sustained, and encouraged home builders to in turn flood the market with new houses. Once the home values reached such dizzying heights and there were no more new buyers, the housing market flew off a precipice.

    Since the housing bubble popped, home values have been plummeting, and the GSE’s are progressively being exposed to greater risk. The CBO’s cost estimate takes this into consideration: “The key factor for the GSEs’ future credit losses is the path of housing prices in the next several months. If the deterioration in the nation’s housing prices continues or accelerates, the GSEs’ credit losses will grow.” And then the Treasury’s new authorities will be invoked, thus putting the taxpayers on the hook.

    With that in mind, it is inexplicable that the CBO’s estimate repeatedly states “that there is a significant chance—probably better than 50 percent—that the proposed new Treasury authority would not be used before it expired at the end of December 2009.” This can only be if housing prices have truly bottomed. In truth, those values are going to be determined regionally based on local economic conditions, and also the forces of supply and demand.

    If the need for a bailout is predicated on the value of homes, and the current drop in housing prices was because of overproduction of new homes over the past ten years, and those inventories still have not yet cleared, then those prices will continue falling until they bottom. Those are market forces at play.

    What’s worse is the banks do not really have that much more money to lend to help those inventories clear, or at least they are much more cautious about doing so in case their current loans go into default. Under current conditions, they need a cushion, and they’re not ready to make matters worse by doubling down on far less than a sure bet. Which means the prices will only fall more. And that will result in yet more credit losses for the GSE’s.

    So, there is no question in the eyes of ALG News that these new authorities will be invoked once enacted, and it seems very likely that such a bailout will exceed the low-ball $25 billion estimate. And once they do, the new authorities will become a permanent fixture of a new Federal housing entitlement unless and until Congress then takes contrary action to get the government out of the business of guaranteeing mortgages. Big Government cannot even keep up with its current entitlements of senior and low-income health care and Social Security—those too are going to go into the red.

    The American taxpayer can ill afford to take on another entitlement. Therefore, after Congress is through with their current bailout—there is no stopping it now—it will no sooner be time to get the taxpayer off the hook. Gerald O’Driscoll of the Cato Institute has such a plan:

    “[W]e have an overall diagnosis and treatment plan: downsizing and capital infusions. In the near term, the capital may come from Treasury because of the dire condition of their share prices. Congress could authorize the Treasury to purchase shares of preferred stock convertible into common shares in, say, five years, but it would have a mandatory conversion feature in 10 years. At that point, the Treasury should be required to sell its common stock in an orderly fashion (but within two years). Socialism in housing finance must not be made permanent.

    “Over the course of the 10-year period, Fannie and Freddie should systematically sell off their security portfolio and raise additional capital. By the end of that period (or sooner, if management desires to get out from under the government’s yoke), their capital ratios should be up to the level of a commercial bank: 6%-8% of assets.

    “Follow these guidelines and at the end of 10 years, perhaps sooner, we could have a truly competitive market in housing finance. No single institution, nor a duopoly, would play a crucial role in housing finance. The idea that a government-sponsored enterprise is needed to provide liquidity is at best obsolete. Global financial markets provide liquidity, except when impeded by the effects of bad, government-directed policies. Credit allocation and easy money created a housing mess that now threatens the viability of even government-sponsored enterprises. Never again.”

    Unfortunately, the current deal being worked out includes no such provisions for downsizing and then truly privatizing the GSE’s. It’s a temporary bailout without a long-term game plan. As Mr. O’Driscoll warns, “Let us not resolve one crisis by sowing the seeds of the next.” And that next crisis could be that the “full faith and credit” of the U.S. will be destroyed because the American taxpayer simply ran out of money.

    ALG Perspective:
    More than 98 percent of the mortgages held by the GSE’s are not in default, and do not look like they will go into default. Nonetheless, bottling up half of all U.S. mortgages into two financial institutions makes positively no sense, because then those “enterprises” pose not just a significant risk to those homeowners and the U.S. economy, but the overall health of the global economy. That risk must be spread out. The GSE’s are not just “too big to fail,” they’re too big to be run by and guaranteed by the government.


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