This week it was estimated that the cost to save Fannie Mae and Freddie Mac, the two publicly chartered but privately owned guarantors of U.S. home mortgages, would total $25 billion over the next two years. Stockholders in both troubled companies saw their shares fall by 45 percent during the second week of July. While Freddies owners experienced a rebound after the Treasury prohibited aggressive short selling of financial institutions stock, 76 percent of its value has evaporated so far this year. Alarming? Yes. But not as alarming as the steps the federal government intends to take in rescuing yet two more companies deemed too big to fail.
In the run-up to the housing crisis that began about a year ago, Fannie and Freddie together accumulated $5.2 trillion in debt by purchasing or guaranteeing roughly half of the nations home mortgages, up from $1.58 trillion in 2003. Although the two mortgage giants claim that their reserves are adequate, regulators impose much lower capital requirements on Fannie and Freddie than they do on commercial banks.
After the two companies reported combined losses of $3.5 billion in the third quarter of last year, investors started pulling out, possibly mindful of the accounting shenanigans Fannie and Freddie engaged in a few years back. Temporarily staving off financial Armageddon late last year, Fannie and Freddie sold $13 billion worth of preferred stock. Additionally, Fannie raised another $7.4 billion a few months ago by floating new issues of both common and preferred shares. And while it may be too little, too late, Freddie now proposes to market another $10 billion in preferred stock. Incredibly, according to last Fridays Wall Street Journal, at least one Goldman Sachs analyst thinks that the two lenders need an additional $53 billion in capital to weather the ongoing mortgage crisis.
And so, Washington sees another chance to expand the size and extend the scope of government control. Treasury Secretary Henry Paulson has suggested extending an unlimited line of credit to Fannie and Freddie and has also hinted at seeking congressional authority to allow the Treasury to purchase shares in the two companies directly. Finally, a complete government takeover of both companies is under consideration.
This solution would potentially expose taxpayers to the companies mortgage liabilities not covered by capital reserves, effectively increasing the national debt from $10 trillion to $15 trillion. It might produce better results than the second option, however, as economic research shows that fully state-owned enterprisessuch as the U.S. Postal Serviceoutperform firms with mixed public-private ownership.
Ultimately, neither government solution will restore the market discipline necessary to purge the economy of the irresponsible business decision-making that caused the housing crisis in the first place. To paraphrase a banker recently illustrated in a New Yorker cartoon, You mean you cant make money lending to people who cant repay their loans? ... Who would have thought? Markets work only if businesses are as free to fail as they are to succeed.
The depths to which Fannie Mae and Freddie Mac have sunk present a golden opportunity for getting the federal government out of the mortgage business. As with the orderly liquidation now underway at IndyMac, the large California thrift that also got into trouble through aggressive mortgage lending, Fannie and Freddie ought to be dissolved and their assets sold to the private sector. Unlike IndyMac, of course, where the Federal Deposit Insurance Corporation will pay off depositors in full up to the $100,000 per deposit guarantee, Fannies and Freddies stockholders may get nothing back.
But no tears should be shed. In recent offerings of preferred stock, the two companies owners have pocketed risk-adjusted rates of return of about 14 percent, yields far higher than those earned by most investors, including those in the major oil companies. For far too long, Fannie and Freddie have enjoyed special, indeed, cozy relations with Washington, facilitated in part by the companies $170 million in lobbying expenditures since 1998 and the $1.5 million they have contributed to members of Congress. They should not be rewarded for putting taxpayers on the hook.