Freddie and Fannie: The Case Against Hybrids

The fallout from the collapse of Fannie Mae (FNM) and Freddie Mac (FRE) stock continues. Yes, the markets have rebounded somewhat. A little good financials news here and there has prevented another freefall, just like with the Bear Stearns weekend of doom earlier this year. But we're in a weird time. J.P. Morgan Chase (JPM) announces that its income fell 53 percent and the stock soars - because it all could have been so much worse.

In this atmosphere, it's easy to lose track of the big goal with any Fannie Mae assistance plan. The goal is not just to help Fannie and her little brother, Freddie Mac, through the next few weeks, but hopefully to come up with some kind of prescription that will avoid any crises in the future.

A couple of thoughts: One is that we should really think hard about abandoning Freddie and Fannie in their current form. Treasury Secretary Henry Paulson has said that he wants to keep the duo as shareholder-owned companies, but it seems crazy to keep them as such with that implicit government guarantee that suddenly looks a lot more explicit. One option is for the government to just take over the damn things and let them, in fact, become government-run corporations or, in time, government agencies.

Sebastian Mallaby of the Washington Post and the Council on Foreign Relations put this forth. His take is that in the long run, we're better off with the feds just running it all. The other way to go is full privatization. Bert Ely, the prescient and persistent Fannie critic has outlined a series of steps that could be taken to more fully privatize the agencies. The same happened with Sallie Mae, the student loan agency. My take is no hybrids—they're great cars, but with agencies like these, it's either in or out for the feds. Any combination of public and private is a recipe to recreate what we've seen thus far—private property and socialized risk.

Larry Summers, the former Treasury Secretary and Harvard University president, who has had the courage to take on liberal orthodoxy in the past, has thoughts on the Creative Capitalism blog about all of this. He writes:

What went wrong? The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation. When there were social failures, the companies always blamed their need to perform for the shareholders. When there were business failures it was always the result of their social obligations. Government budget discipline was not appropriate because it was always emphasized that they were "private companies." But market discipline was nearly nonexistent given the general perception--now validated--that their debt was government-backed. Little wonder with gains privatized and losses socialized that the enterprises have gambled their way into financial catastrophe.

I don't know what the very best way out of the mess is. On balance, it seems like it was the right thing to extend a government hand to Fannie last week. But going forward, the larger restructuring that takes place shouldn't leave us vulnerable to this kind of calamity again.

Comments

[DCBill:]

Matt--The collapse of F/F "stock," but not the companies. Big difference.

It's important to "scream" that neither Fannie nor Freddie has asked for emergency Treasury/Fed help and both look like they have sufficient capital and salable assets on their books to counter any losses.

The legislation moving through Congress and likely to be sent to the President this week does have numbers regulatory constraints including, including greater capital.

But, what you are asking is whether we should jettison the "secondary mortgage market"--with its F/F presence--which until the subprime mess--has done a superb job of standardizing mortgage products and lowering consumer costs.

What's the alternative? Banks and thrifts making ARMs and holdingthem? Direct Treasury lending or HUD lending? How about a "new" Fannie and Freddie, called soemthing else but structured the same?

I think we are better off with what we have and making it work better, especially since there is no proof the this model doesn't work.

2008 Jul 20 05:31 PM

[User 229302:]

It is very intresting that some think there are real solution for capitalist financial problems, in reality it is just buying time and it gets worst.
Today There is no hope that capitalism will become productive in a sence that will imploy all those that spend and kip capitalism healthy, today capital in magor cases can not gain minimum rate of intrest, so, please expect to get worst!
Meaning of life has been greately compromised, and great majority of humans are alive without living life, without being productive in a real sence.
Trading in stock market and taking away peoples livelyhood and calling it free market economy is what is available today and that is the most unhealty way of investment that it is awailable, but with very limited understanding, that is what general public has to setle for.
The real purpose of social life ios so the members of society to help every one to have a good life, is that what we are doing in this society which is #1 in most of what we see. very questionable with human standards right!

2008 Jul 20 06:24 PM

[gabe borens...:]

The FNM and the FRE are working quite well in the current form.It is the irratinal rumors and the panic disseminated by some market segment and psudo economists at a well known financial news TV program that have created the debacle .It was interesting to observe the distortions exaggurated geometrically as the short open interest had risen in both companies .The officials in these corporations did not ask for assistance as their capital requirements were above the specified level.
The treasury intervention was a necessary catalyst for the rally as it finally had settled the issue of the implicit government guarantee.
Both agencies are functioning well under the current status .There is no reason to punish the share holders by "nationalizing" both institutions.
The U.S guarantee could be modified by allowing the tresaury to become an investor in the both agencies.
I am glad that the irrational "short " assault at these very relevant agencies has failed.We still may see mega short covering in the period ahead.The worst of the housing turmoil is behind us and the liquidity that the FRE and FNM provide will become an integral part of recovery in the housing sector.
Perhaps some mega losses from the shorts,will finally stabilize financial sector.

2008 Jul 20 09:17 PM

[bbzz24:]

According to GAAP those companies are inslovent. In fact any entity that leverages up to 200 times can become insolvent any moment as 0.5% unfavorable swing in asset prices wipes out all equity.
However, we see that even insolvent companies can borrow at near treasury rates aslong as they are backed by the government. This is what keeps Phonie & Fraudy in capital markets.
And dont forget that what keeps them still from borrowing is the positive cash flow which just reminds me that their real 'assets' is not the home loan collateral but rather the willingness of the borrower to continue servicing the loan. So arent their books still cooked given all this?

2008 Jul 21 01:49 AM

[tomc368:]

What is lost in all the discussion is the role that the unregulated and non-transparent hedge funds played in the demise of the stocks of these entities and, consequently, their severally injured ability to raise additional capital so they could solve their own problems. The elimination of the 'uptick' rule and the vast ballooning of naked shorting since then has contributed more to their problems than the any other thing.

2008 Jul 21 04:53 AM

[Jason Rines...:]

That's a good point TomC. But keep in mind what many responsible economists said in 2004-2006 about real estate, iBanks, lawmakers and the Fed. Market manipulation was occuring. Now during that time Frannie and Freddie got the benefits of the free market manipulation. That also means it is getting the detriment. That is why it is always better to have a completely "free" market at all times. Lawyers make horrible lawmakers. This tale begins in Washington in 1992. So the Efficient Market Hyposis has failed has it? Then the bigger question is, what damage do we all as American's share? Right now, only a small portion seem insulated as we fix the problem, that is call Chronie Capatalism. It was what brought down Rome.

2008 Jul 21 04:04 PM