Fannie and Freddie's Woes

Fannie Mae and Freddie Mac, the giant Congressionally chartered entities that act as market makers for the resale of mortgages in the United States, are supposedly in trouble. On the verge of failure, in fact, if the whiners in the media are to be believed.

The problem is that they’re expected to need to raise in the neighborhood of $75 billion in new capital as a result of a new financial accounting standard on off-balance sheet entities. This seems like a huge amount, until you consider that they each have portfolios worth, conservatively valued, literally trillions of dollars. The difficulty is that this is not a good time for raising money in the mortgage business.

Hank Paulson wants to solve the problem by regulating them more, which typically means raising their capital requirements even further, adding insult to injury. This is reminiscent of nothing so much as the Federal Reserve action, documented by Milton Friedman and Anna J. Schwartz, reducing the money supply at the beginning of the Great Depression. The action that made Ben Bernanke say, “Yes, we did it. We’re very sorry. We won’t do it again.” Maybe he won’t have to, if the Treasury Department does it instead.

Well, okay, it’s also reminiscent of the government’s piss poor handling of the off balance sheet liabilities of Enron. When it became apparent that Enron had a big exposure the government responded with heavy handed threats of regulation of its bankers who responded by beginning to call loans. Enron was awash in cash one day, the government threatened and Enron was bankrupt. As bad as the Enron failure was, it was a minor economic ripple compared to the potential that either of the mortgage giants, let alone both, fail.

There’s certainly room to evaluate the structure and regulation of the mortgage giants, but that doesn’t address the short term issue which is itself the result of throwing new regulations at them at a bad time, kicking them when the mortgage markets they make are down. Realistically the options in the short term are to encourage them to raise private capital, to let them fail and virtually eliminate the US mortgage market, or directly or indirectly bail them out with taxpayer money.

There is a short term solution that’s pro-growth, pro-market, non-inflationary and leaves open the option of slowly raising those capital requirements to a safer level as they raise capital privately: make the earnings of Fannie Mae, Freddie Mac and, for good measure, Ginnie Mae securities tax free for 10 years, both the debt and equity securities. The class warriors who want to encourage more regulation and eventual nationalization of the pair won’t like that. They’ll paint it as a “tax break for the rich.” To some extent they’ll be right, but the rich in this case (as in most) are the little old ladies whose retirement savings are tied up in the supposedly safe income producing Fannie Mae and Freddie Mac securities and who will be broke and eating cat food if the government “bails out” the pair. A cynic might think that’s the goal of the class warriors.

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