Is the Federal Bailout of Fannie and Freddie Too Clever?

Today, July 24, 2008, the Dow Jones Industrial Average fell 283 points. Fannie Mae stock dropped almost 20% and Freddie Mac stock fell more than 18%. The financial press attributed the stock market's swoon to bad news on the housing and unemployment fronts.

The downturn in Fannie's and Freddie's stock wasn't supposed to happen. Late last week, the Bush 43 administration announced with great fanfare policies to prop up Fannie and Freddie. Prominent among these policies was a proposal that the Treasury Department be given wide discretion to lend to and invest in Fannie and Freddie as much as it wanted on whatever terms it considered appropriate. The announcement of the bailout plan sent Fannie's and Freddie's stock, along with bank stocks, bounding upwards. It appeared that the administration meant to protect not only Fannie's and Freddie's creditors, but their stockholders as well. Who wouldn't buy a stock that has government protection?

But this plan may have been too clever by half. The idea is that by supporting Fannie's and Freddie's stock prices, the two companies would be able to raise capital by issuing more equity, which would absorb the mortgage losses that we all know are coming. The cost to the taxpayers would supposedly be relatively small because taxpayer dollars would only provide support while private equity would do the heavy lifting (and take the big hits). Presumably, private equity would get greater profit potential to compensate it for taking the risks of the big hits.

The problem, though, is that we all know the big hits are coming. Estimates of the losses from the mortgage mess and credit crunch tend to run over $1 trillion, and have gone as high as $2 trillion. Most of these losses haven't been realized yet. Fannie and Freddie, who either hold or underwrote about half of all mortgages issued in the U.S., have some serious exposure. It won't be a small number. Many tens of billions seem almost a certainty. Over $100 billion wouldn't be surprising.

Private, often foreign, investors have done poorly investing in mortgage-bedeviled banks over the past year. Many of the major banks are looking for more capital as the flood of write downs continues. The foreign investment funds that got burned the first time around may be just a wee bit hesitant to step forward and accept Treasury's invitation to take a bullet for Fannie or Freddie. It's one thing to invest with the risk of further losses. It's another when further losses are a virtual certainty. At some point, when the mortgage and credit crunch losses loom large enough, the Euro, yuan, rupee, won, baht, yen and so on begin to look like better bets than the dollar.

If private investors shy away from providing fresh equity to Fannie and Freddie, the Treasury Department's plan could be in serious trouble. The Congressional Budget Office estimated the likely cost to taxpayers of the Fannie and Freddie bailout at $25 billion. But this seems low, especially considering that the Treasury Department requested that the borrowing it did to bail out Fannie and Freddie not count against the federal government's debt ceiling. The debt ceiling is currently $9.815 trillion, with $9.5 trillion in debt outstanding. If the cost of bailing out Fannie and Freddie could so seriously implicate this ceiling that Treasury wants it excluded, that would mean that the current buffer of $315 billion probably isn't enough. Not a good sign.

Private investors might indeed refrain from investing in Fannie and Freddie even with Treasury warming up in the bullpen. Perhaps the stock market figured this out, and decided that discretion would be the better part of valor. That would explain the sharp dropoff in financial stocks today.

The baseline problem for the current financial crisis is that a shipload of losses remain to be recognized. These losses were created by the reckless and downright stupid lending done in the Fed-fueled credit bubble. The crisis won't pass until the losses are booked. One way of doing this would be to create a new mortgage agency, which could implement federal policy with a clean slate and no pile of liabilities that may be known or unknown. Fannie and Freddie could be gradually liquidated, with their stockholders, bondholders and other creditors taking losses that would be appropriate to their standing in the companies' capital structures.

Treasury's current approach of throwing taxpayer dollars at these losses is reminiscent of the mistakes Japan made in the 1990s, trying to squirm its way out of its stock market and real estate bubbles. Among its policies were government subsidies to failing banks and businesses that were called "zombie businesses." The Japanese economy stagnated, and then stagnated some more, only to continue stagnating, even to this day. The Japanese finally figured out what they had to do and booked their losses. But they took so long to do it (and wasted so much national wealth subsidizing zombie businesses) that they still are going sideways economically speaking.

We can learn from Japan's mistakes. But that would require putting expediency aside and doing the right thing. In Washington, especially in an election year, that's definitely not something to bet on.