Unprecedented Government Bailout

My title is just one way to put it. "Fannie/Freddie Shareholders Wiped Out" is another. Over the weekend, the U.S. Treasury announced it's plan to take over Fannie and Freddie to prevent bankruptcy and shore up the mortgage market. Basically, the government effectively now owns Fannie/Freddie and is using the taxpayer's balance sheet to keep the world's financial system from complete meltdown.Fannie and Freddie are what is known as "Government Sponsored Enterprises" or GSE's. While these financial behemoths have public shareholders and nothing to do with the government, they have always been treated as quasi-federal agencies because of the historical relationship.  Unlike other financial institutions, Fannie/Freddie have their own rules, their own capital requirements, their own regulator and some specific business mandates set by Congress. This special relationship caused the markets to always assume an implicit guarantee by the government for their operations. That assumption turned out to be true for debt holders.

Back in the dark ages of finance, the government chartered the GSE's to provide liquidity and available capital to the mortgage markets. The idea was, if a couple of companies were created to do nothing but create liquidity in the mortgage market, then the credit cycle would not impact hard working Americans who are just trying to get a reasonable mortgage.  And it largely worked.  Unfortunately, like much in politics, it was allowed to grow into a monster.

The leverage allowed Fannie/Freddie exceeded 40x, whereas most banks are levered around 10-12x.  What politician would vote against the lobbying for Fannie/Freddie to increase their leverage and thus against "housing" or "affordable housing" and thus the American Dream?  Both parties succumbed to some of the most powerful lobbying around.  A few brave souls however, namely former Rep. Richard Baker and former Fed chair Alan Greenspan, were vocal but ultimately ignored critics of the GSE's.

Fannie and Freddie collectively support nearly $7 trillion of mortgage debt.  That is not a typo- $7 Trillion. Because such debt has always been considered AAA or as safe as government debt (because of the implicit guarantee), it forms the foundation of the entire banking system in the form of equity, preferreds, senior debt, and mortgage backed securities (MBS).

Now that enormous leverage has come to bite the GSE's. Relatively small losses (about 1%) have destroyed tens of billions in capital and investors are questioning GSE solvency. To keep GSE solvency from rippling through the system and causing true financial collapse, Treasury Secretary Hank Paulson has effectively taken over the firms.

All of this screams for spin and rhetoric- the debt holders were saved from default, is that a "bailout"?  Yet shareholders were almost completely wiped out.  Now taxpayers are on the hook to guarantee all that debt.  Does this conform to the Republican ideology of letting free markets work?  How does it reflect on Democrats since their affordable housing ideas helped grow the GSE's beyond what is reasonable?  What does it say about the "moral hazard", which is the idea that market participants will take on more risk because of a precedent that government will prevent ultimate loss?

Frankly, I don't know.  Yes, it creates a moral hazard.  Yes, it is a bailout of sorts.  Yes, shareholders deservedly got wiped out.  Yes, it was completely necessary.  Regardless of your political/economic philosophy on free markets and moral hazard, if the government had not acted, it is quite possible that this crisis could have quickly disintegrated into Great Depression II.  Given that the government caused the problem by enabling Fannie/Freddie, isn't it better they fix it?  I do know it would be erroneous logic to say the government ought to let the system fail just to adhere to free market principles. Holding to a free market principle such as "I never would have allowed Fannie/Freddie to begin with", is not relevant when they do exist and a crisis happens.  This is like cutting off your nose to spite your face. 

Would this have happened without Fannie/Freddie?  Quite possibly.  Imagine Congress relaxing restrictions for bank's leverage on mortgages to promote a deep, liquid mortgage market and availability.  Or imagine thousands of new mortgage banks being created to meet the demand during the housing bubble.  We can not rewind the clock and run the experiment again, but there is no reason to suspect all the blame belongs on Fannie/Freddie and Congress- as I mention in my Banks, Bubbles and Blame post.

What should this mean to the economy?  For starters, stock markets the world over rallied today taking the announcement as good news.  Indeed, this is "good" news as the uncertainty over an enormous weak link is alleviated.  Unfortunately, impressive and climbing rates of foreclosures and defaults are not helped by this action.  Bad loans will continue to cause losses at financial institutions and result in capital being raised.  It does not help the inventory of homes for sale either, but it does ensure access to loans for qualified borrowers, without which the real estate markets would be much worse off.

This weekend's action will be one discussed and debated for decades to come, ultimately making its way into financial textbooks.  History in the making, my friends.