Less than two months ago, Treasury Secretary Hank Paulson told Congress and
the country that if he were given virtually unlimited power to intervene in
the affairs of Fannie Mae and Freddie Mac he wouldn't have to use it.
"If you have a bazooka in your pocket and people know it, you probably
won't have to use it," was the inartful way he put it.
Well, Paulson was massively wrong, and remarkably quickly so. Worse, the
powers that Paulson successfully sought, rather than calming markets,
alarmed them further.
Fannie and Freddie do not originate mortgages. Instead, they buy mortgages,
bundle them into securities, guarantee their performance and sell them to
investors. This frees up funds from the mortgage originators to continue
lending. They also hold some of the mortgages they bundle and buy
mortgage-backed securities from others for investment.
Fannie and Freddie have to raise capital to buy mortgages. The threat of
federal intervention severely hampered their ability to do so. If there
were a federal intervention, no one knew what would happen to existing
shareholders and debt holders.
The seizure of the two companies orchestrated by Paulson over the weekend
wasn't a bailout. The management of Fannie and Freddie were still trying to
make things work despite the added burden of the uncertainty created by the
bazooka in Paulson's pocket.
Paulson concluded that they weren't going to make it. He decided that the
federal government was going to take them over.
So, the federal government put the companies into conservatorship. It also
awarded itself, for both Fannie and Freddie, a billion dollars in equity
with a guaranteed rate of return of 10 percent and the right to purchase,
at terms it sets, up to about 80 percent of the company.
This wasn't even a takeover. It was thievery, Mafioso style.
In the modern world of global finance, Fannie and Freddie should not exist.
They are anachronisms. And they may not have made it.
But they deserved the chance to try, rather than being given a choice they
could not refuse by Godfather Paulson: accept conservatorship and preserve
some position for your shareholders or be involuntarily taken over with
shareholder equity being perhaps totally extinguished.
Paulson has asserted and seized a remarkable degree of authority over
private economic activity. He also forced the fire sale of Bear Sterns to
J.P. Morgan Chase. He even dictated the price of the transaction.
In the process, he has put taxpayers at risk for hundreds of billions of
dollars in mortgage financing. Fed chairman Ben Bernanke has willingly
allowed Paulson to use the Federal Reserve as a piggy bank for his power
grabs. As a result, half of the Fed's assets now consistent of junk other
investors are shunning.
This is all supposedly to prevent systemic financial risk. This is the
theory that if one big boy fails, all the big boys will fail.
In Fannie and Freddie's case, the consequences of their failure and their
indispensability to mortgage finance are both exaggerated.
The mortgage-backed securities Fannie and Freddie guarantee are mostly held
by others. The underwriting on the underlying mortgages was pretty sound.
The delinquency rate on them is just around 2 percent.
So, if the guarantees became doubtful, the market value of the securities
would decline, but not by much.
And there are other ways of creating a secondary market in mortgages. In
fact, the existence of Fannie and Freddie, with their substantial
competitive advantage from a perceived (now explicit) governmental
guarantee, hampered the development in this country of the covered bond
approach that predominates in Europe.
With covered bonds, the mortgage originator keeps the mortgage. The
originator then issues its own bonds backed by its mortgages, replenishing
its capital to keep lending. But because the originator is on the hook for
any defaults on the underlying mortgages, underwriting tends to be tighter.
Paulson, in addition to riding roughshod over the private economy, is
really trying to continue pumping money into housing when the market is
screaming, about as loudly as it can, that there's been an overinvestment
in housing.
President Bush's previous treasury secretaries — Paul O'Neill and John Snow
— were thought to be mostly ineffectual. The country didn't know how well
it had it when Bush's treasury secretaries were merely ineffectual, rather
than perniciously effective.
