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The Perils of Fannie and Freddie, part II

Posted by: Michael Mandel on July 14

Investors figured out today that the Paulson/Bernanke rescue plan is not going to save Fannie and Freddie in their current form as private companies. The stock of the two companies dropped—5% for Fannie and 8% for Freddie—while Freddie had a stronger than expected demand for its debt offering.

This is exactly what we would expect. The two companies are now on the inevitable road to being bailed out, nationalized, and shrunk—not as bad as being drawn and quartered, but not good either.

Why do I say inevitable? We now have a situation where the Treasury Secretary and the Fed Chairman have taken the first small steps towards placing the full faith and credit of the U.S. government behind two private financial companies. These steps cannot be undone. Once the promise has been made to investors—however vague—the government has to step up to fulfill it.

The logical end state here is a full takeover. It’s simply not sustainable for two private companies to be able to do business as usual with a full and explicit government guarantee. It’s not fair to other companies, and it opens up the door for all sorts of risk-taking which could make the problem even worse.

However, the markets have correctly assessed that Paulson/Bernanke are committing to making the debtholders whole, but they are making no such promises about the shareholders. In fact, good central banking practice says that the shareholders should take a very deep haircut if there’s a bailout/takeover, just like what happened with Bear Stearns.

My timeline for the full transition, as per my earlier post, is still the beginning of the next administration. I think the next president, whether it’s Obama or McCain, will be looking at a $400-$500 billion bailout of the U.S. housing sector. This will encompass not just Fannie and Freddie, but a wide buy-up of bad mortgages—just getting them off the books of the financial sector at a substantial discount.

It’s worth looking at the S&L crisis of the 1980s to see how that might work. The total size of the bailout back then was $225 billion (see the GAO report, Appendix I, page 31). The Resolution Trust Corp recovered $140 billion, so taxpayers had to put in roughly $85 billion (these numbers are very rough).

Assuming that the same ratio holds this time, a $400-$500 billion bailout would end up requiring $150-$180 billion of taxpayer money, spread out over several years.

That’s a lot of money—which is why I don’t think anything major can be done with the presidential election looming, though Paulson went further than I thought he would.

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Reader Comments


July 15, 2008 02:33 AM

Compared to the costs of the stupid war in Iraq, they are minimal. How much are we wasting every month in Iraq?

Matt Lechner

July 15, 2008 02:45 AM

While in some very limited instances short term gov't involvement may be necessary, the private sector can and will want to handle its own requirements. The less gov't involvement the better. The gov't is not there to be America's banker, or indirectly to be the world's banker. Banking and housing finance must not be treated as a social program sector, nor as a "heads I win, tails you lose" proposition for lenders either. It is a business, an industry, and the basic structure of the industry may be transitioning from a scenario where banks and non-bank lenders try to immediately sell all the loans they originate to the gov't - to a scenario where the banks hold the loans on their own books. Let's hope that your prognosis is early and too extreme. The gov't response thus far has been reasonable and appropriate, however IndyMac should be required to change its name to one that can not be confused with a government agency or quasi-agency like Freddie Mac or Farmer Mac. IndyMac does not have GSE status, and can not be allowed to use a name that is confusing on that point. Industry-wide, some tax incentives should be considered for revitalization, such as significantly shorter depreciation schedules. They are currenty too long and discourage some forms of investment.

Matt Lechner - CFP, CRPS, CIMA, FRM
Chairman - WSSIG, the Wall Street Special Interest Group


July 15, 2008 03:22 AM

Taxpayer Money? Don't all of them South American Oil producers owe us a small fortune? Time for some NAFTA payback.

I'm always afraid there are unseen aspects to this. I worry that some of these watch list banks aren't giving complete figures on vacant houses that are pending foreclosure which concerns me because this may be one final balance sheet manipulation of these rapaciously irresponsible
junk-bankers. They should be called upon to account for any limbo properties that have been pending forclosure in excess of six months with no activity and no occupancy and take them on as Real Estate Owned and flip them or rent them even if it is at a loss. This (tied with a needs based modification policy) will stimulate the economy if they start moving even just some of these homes.

I just don't think it is as bad as all this in the long run. But the Govt. needs to keep control on these irresponsible money managers like Countrywide & Kin. I'll bet that many of the same financial managers who let it get this bad are still retaining directorships, vice-presidencies leadership roles etc..

I have a pretty smart friend who tells me you have to address the problem.

As to the credit scare, I'm a big fan of going to the 80% Loan To Value on all new loans, getting rid of high bank, appraisal and origination fees and requiring a claim accounting policy as to any Federally required Private Mortgage Insurance proceeds available to defer loan losses.

You want a strong dollar? A strident monetary policy starts with quality collateral. You get quality if you don't dilute the value of your collateral by allowing mortgage bankers and originators to circumvent quality control rules to increase volume.

Also, its easier for a Borrower to pay back if you don't load him up with hundreds of dollars in upfront fees and PMI payments.


July 15, 2008 04:04 AM

As a Government chartered corporation for the past 72 years with a implied Fed backup, Fannie will be little changed with new laws now providing a more legal backstop. Also, Fannie's portfolio of 5 trillon dollars in mortgages are mostly conventional full documented loans that are performing just fine. The laws were to quell rumor- mongering which bloodied the stockprice and had short-sellers raking in ill-gotten windfalls..

Ray Lopez

July 15, 2008 05:04 AM

Flawed logic by the author--is he short FNM? The late 80s S&L crisis was a decade in the making and had numerous causes, see here:

By contrast, today's crisis is a classic 'run on the bank', since according to GAAP, banks are solvent. Only where panic refuses to make a market is there a problem valuing assets, which then have to be artificially valued by a model. Delinquency rates for mortgages are historically high but still in the low single digits. Once the panic subsides, these companies will do fine. As for nationalization, that's a bad thing, and if anything for the good of the country the Federal Government should have renounced any backing of these GSEs, but, as a FNM shareholder, I don't mind.

Pete Kusnick

July 15, 2008 07:19 AM

Don't fix what ain't broke. Wait til it's broken, then smash it to pieces. that way we have a new plan.

Seems this event is part of our business cycle now: plan for failure. That's the Congressional motto. I gave up on our pols a long time ago. Even the investment bankers are being forced to sell their souls and they don't have one. Guess they'll borrow mine. Hey, there's a good joke in there: did you hear the one about the banker who shorted your soul.

T Taylor

July 15, 2008 08:17 AM

I don't think a "bailout" of the American housing sector is going to be of that magnitude. I don't think you can equate the S&L crisis with the housing crisis in this example. The investors that hold the paper on these homes are going to have to take the losses, many of which are those that invested in the subprime market. Moving these loans into government-backed programs such as FHA loans does not necessarily have to create a "cost" to the American taxpayer.

While there may be some costs, I think $150-$180 billion is way too high. If it does end up costing that much, then we need to look at some other ways to help the housing market.

Pete Kusnick

July 15, 2008 08:34 AM

Jim Rogers, no relation to Mr. Greenjeans, pleads for the US to let Fannie and Freddie fail. He considers the risks to the nation and rebuts, who cares if I make a bundle?

His surgerical skills: the patient died but the operation was a success.

alexander mettmann

July 15, 2008 09:22 AM

Where is the outrage??? When will America wake up and stop a consortium of private banks running the entire financial system of this country. I want my Gold back that the government gave to the central bankers in 1913. Stop the money printing presses, this is mayhem.


July 15, 2008 11:03 AM

The agencies should file for bankruptcy and re start from the ground up. A government bail out isn't without consequences for our future generation. With rising prices of fuel,food and devaluation of our currency, it will take a long time for things to get better.


Mike Mandel

July 15, 2008 11:25 AM

Ray Lopez writes:

"Flawed logic by the author--is he short FNM?"

Just a word on my stock holdings. With one exception, I only hold broadly-diversified mutual funds, in part to avoid such potential conflicts of interests. The only exception, of course, is MHP.


July 15, 2008 12:23 PM

As a renter, I find this frustrating. In addition to all the other tax benefits offered to homeowners, now the goverment is going to bail out freddie mac and fannie mae using my tax money.

At some point, the goverment should stop subsidizing home values/debt and simply let the prices fall.


July 15, 2008 12:26 PM

Lew Rockwell ( says; "It seems ironic that the announced mega-bailout of corporatist boondoggles Fannie Mae and Freddie Mac - of the government-connected rich at the expense of the rest of us - has caused stock markets all be over the world to tank. But since the whole financial system of Fed inflation and fractional-reserve banking is fundamentally unstable - indeed, based on fraud and State counterfeiting - once it starts to go down there is probably no stopping it. The business cycle unleashed by Printing Press Alan Greenspan after 911 must run its course. Maybe Herbert Hoover Bush, Printing Press Ben Bernanke, and the pygmies in Congress can temporarily "restore confidence" (as conmen can fool the marks again) or maybe this is the big enchilada. In any event, don't trust the banks, believe the opposite of what officials tell you, stop as much spending as you can, increase your savings, and buy some gold. Oh, and get used to your house, because there will probably no selling it and moving. Instead, educate yourself about what the Fed has done to us and get angry at the criminal establishment. Stop the Rip-Off!"


July 15, 2008 12:41 PM

When will the madness stop??These organizations should be privatized,not taken over by the government!!Stand by and make whole the holders of existing bonds,wipe out equity holders,then continue operation as private entities.To make whole existing bondholders,may cost us the taxpayers some money,but at least the bleeding would stop at some point.As private entities the cost of new mortgages would go up,but this is part of getting away from living beyond our means.What other country subsidizes home buying the way we do?


July 15, 2008 01:06 PM

We are not wasting money in Iraq. We are in Iraq for a reason, which is to help them out as well as defend our own country. If you live in a country plagued by terror, under an evil dictator, you'd expect some help. Stop ratting on the war on terror, since without this, we wouldn't be near as secure as we are even today.


July 15, 2008 01:07 PM

Wow, so the FED says they are going to bail out Fannie and Freddie. Care to guess whose butts theyre saving? Think about the damage to the economy the FED causes every time it creates hundreds of billions of new dollars out of thin air to finance the governments relentless spending for corporate welfare and endless wars of aggression. This is from a CNBC interview: Sen. Tester asked about a 40% devaluation of the dollar over the last 4-5 years, Bernanke said he thinks it's more like 25%. At that point CNBC broke off for a quick market report. Now easy boys, we cant be telling the American people that kind of truth about our banking-corporate-political scam operation, now can we? Who knows, the suckers just might begin to catch on to the real reason why the economy is imploding.


July 15, 2008 01:17 PM

If Fannie & Freddie are "too big to fail", then it is time for them to be broken up into as many competing pieces as is necessary to make them small enough to fail. Then their independence, and risk, should be made crystal clear to the street. No implied Federal backing. Public backing of risk taken for private profit is a recipie for gambling, and the loss of other peoples $, as the S&L problems in the 1980's, and now this mess, clearly demonstrate.


July 15, 2008 01:39 PM

This entire issue is a non-issue. Not sure why they orchestrated the temporary panic, but now they are backing off:

Tuesday July 15, 1:36 pm ET
By Martin Crutsinger, AP Economics Writer

Bush administration: no immediate plans to extend emergency loans to 2 mortgage giants

WASHINGTON (AP) -- Treasury Secretary Henry Paulson said Tuesday the Bush administration has no immediate plans to extend emergency loans to mortgage giants Fannie Mae and Freddie Mac or to purchase the stock of the two companies.

Paulson told the Senate Banking Committee that the assistance plan put together by the administration and the Federal Reserve over the weekend was intended to serve as a backup if needed.


July 15, 2008 02:06 PM

To SS: So you like unnecessary, unjust wars of aggression? You honestly believe that Saddam was behind 911 and posed a threat to security and prosperity of the
American people? Good Lord man, one doesnt need to look half way around the world for threats to our security and prosperity. Look no further than our very own Rome on the Potomac for REAL threats to our liberties, security and prosperity. Seriously, you need to educate yourself. Read: The Costs of War - Americas Pyrrhic Victories by John V. Denson. This book will prove to you who your enemies really are. Go for it my friend; you have nothing to lose - except your ignorance.


July 15, 2008 04:02 PM

If I were an executive at INDYMAC, Fannie Mae, Freddie Mac or any other corporation and I was making 5 to 30 million per year, I wouldn't give a @@## about the long term financial condition of the company either. Just give me 5 or 10 years like INDYMAC had and I would laugh all the way to my island paradise too.


July 15, 2008 04:55 PM

require every originator of mortgages to keep a share of each mortgage on their books. Doesn't have to be large 10% would be fine. But if they are on their books then as part of the bank examination process they will have to demonstrate that they are appropriately documented or else they would classified which no bank wants to do. The other obvious change is to allow the originator the authority to make any loan modifications they deem prudent.

bob m

July 15, 2008 05:22 PM

Ray Lopez is correct. The author's use of the word "logical" to describe one of a million possible speculations is interesting. Anyone who thinks that it's immoral or too expensive to stand behind the GSE's should just take a look at the stock history of every public financial company in the world. Failure is not an option.

Mike Reardon

July 15, 2008 05:40 PM

I think Congress will give up the cash to establish a reserve under home loans, some from of full guarantee under the smaller loans at least.

That and greater collateralization for larger home loans will in the end create a higher value debt instrument in housing than they started with in this bubble.

That Federally guarantee housing market will then end as a exponentially leveraged valued target one more time. Its building it out over the next few years that will produce a more valued asset going forward.


July 15, 2008 06:01 PM

FRE and FNM are worthless. Pity Capital who 10% and 20% respectively on behalf of their investors! But wait, this is the end game for the next "free lunch" for wall street investment banks at the expense of the people for whom FRE and FNM were created. No they weren't created so that a cartel could pay dealers to travel first class and drive ferraris when they touched down. They were created for low income families to assist them in buying accomodation that main street banks wouldnt give mortgages to. So where's the last hurrah? Well let's see, Paulson has friends inside Wall Street, so I guess it must be "spread contraction" to Government bond yield curve levels. A windfall! A ten year fannie mae bond at +150 goes to flat, that makes 8 years duration times 1.5% multiply that by the 5 trillion oustanding and watch the nice transfer of wealth from main street to wall street, a bailout of foreign investors and a miraculous rescue by our wonderful financial whizz kids. Oh by the way, your taxes will now be splt 50% on debt servicing and 50% on the pentagon to fund Bush's phoney war and if you think you are getting medicare and medicaid at anything other than 10 cents in the dollar you expected, think again. Paul has the right of it, break them up, start small franchises with state and city backing, not federal backing, with a return to the original FRE and FNM mandate to low income families.


July 16, 2008 12:24 AM

To Ronald,I can see how you as a renter would be absolutely livit about the prospect that you and all other renters will be asked to bail out homeowners with your tax money.I am a homeowner,but still I am against any bailout.However all renters should unite to let your elected officials know how ticked off you are!!

Joe Cushing

July 17, 2008 09:36 AM

If there is a bailout the lenders need to take a deep haircut as well. A loan is a risky investment just like a stock is. Whoever invested in Freddie/Fannie/bank debt needs to pay for taking on such risk.


July 21, 2008 09:12 PM

Hey Mettman, good idea. We can get that gold back now for a great inflation adjusted price. Keep some in American hands. Exercise the only power that we have. Buy now.

Mike Mandel

July 22, 2008 11:16 AM

Viking writes:

"Stand by and make whole the holders of existing bonds,wipe out equity holders,then continue operation as private entities"

This would still be a bailout, and it wouldn't help a lot of small homeowners.

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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