The Real Test of the Not-Yet-A-Plan Fannie & Freddie Operation

I must admit to being hopelessly naive. The Fed opens its discount window to Freddie and Fannie, which is an admission that there is a problem but not much of a solution, since the GSEs are certain not to use it (accessing the discount window is a kiss of death, seen an admission that a firm is desperate).

Treasury Secretary Paulson makes a statement which presents in the vaguest possible terms a plan which falls far short of a remedy for the GSEs. These measures merely serve to stabilize the patient; there is no, zip, nada acknowledgment that major surgery is needed (Felix Salmon has an amusing but pointed parsing of Paulson’s remarks).

Oh, minor detail, the plan still has to be approved by Congress, which will hopefully roll over. But what if it doesn’t? Anyone with an operating brain cell knows that these moves put the US on the path to having taxpayers assume Fannie and Freddie liabilities. That in the end is probably unavoidable.

But the largely positive reaction in the press is simply mind-boggling and the Asian market response, particularly a rise in the dollar against most currencies, says that investors approve (update: gains early in the day reversed, largely on oil worries). Um, having to admit you are moving down the path of the lesser of two evils is far from good, at least in my book. particularly when six months ago most people had no knowledge that this course of action was even remotely a possibility.

Clive Crook in the Financial Times is far more clear-eyed about the matter:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

In the end, that astounding prospect might be the outcome. Partial or outright nationalisation of the housing lenders – colossal pseudo-private entities that own and underwrite US housing loans – would add some or all of their $5,000bn (€3,144bn, £2,513bn) in liabilities to the government’s balance sheet. While it is true that the agencies (unlike the government) own housing-related assets that roughly match those liabilities, the still-collapsing housing market makes this a lot less reassuring than one could wish.

Covering the agencies’ losses on their loans and guarantees is going to require an actual outlay, which will fall on taxpayers. You could plausibly call the rest – namely, bringing these “government-sponsored enterprises” explicitly inside the public sector – just a bookkeeping entry. But what an entry! It would surely shake financial markets, raise the government’s cost of funding and put heavy downward pressure on the dollar.

By contrast, Paul Krugman, Princeton colleague of Bernanke, joins the side of the boosters.

Christopher Wood, in a pre-Paulson edition of his Greed & Fear report, correctly anticipated that the Administration would attempt an optical rather than a real solution, but doubts that that will succeed:

The problem right now is that the Bush administration remains, understandably, reluctant to saddle US taxpayers with the US$5tn liability represented by Fannie and Freddie. Yet continuing to pretend that there is not a fundamental problem of solvency is serving only to damage further the fast diminishing credibility of Federal Reserve governor Ben Bernanke and US Treasury Secretary Hank Paulson. This is clear from the renewed weakness in the dollar and the renewed surge in the price of oil. The latter market action is further evidence, if it is needed, that oil is trading as a non-dollar proxy.

It is clearly possible that the administration may be able to come up with some fudge which allows Fannie and Freddie to continue to function in their present anomalous status for another few months until the November presidential election. But GREED & fear would not bet on it. The housing market is deteriorating too fast as is clear from Fannie and Freddie’s rising delinquencies…… Fannie and Freddie’s financial credibility cannot withstand any form of semi-detailed scrutiny. Fannie and Freddie have a combined “regulatory capital” of US$86bn, while the two own or guarantee US$5tn worth of US mortgages between them.

The result of the above is that the Washington establishment is now paying the price of having allowed the dangerous anomaly represented by the half public sector and half private sector Fannie and Freddie to function for so long and to become such a vast part of the US financial system. Indeed Fannie and Freddie, by their aggressive accounting practises and by their willingness to buy dubious “private label” mortgage–backed securities, were in no small part responsible for the excesses of the housing boom.

Note that Wood is not alone in the view that the GSEs contributed to the housing bubble. Jim Hamilton has said the same thing, repeatedly. The latest instance:

The GSEs’ book of business represented 25% of outstanding residential mortgage debt in 1990 but comes to 41.4% today. It is hard to avoid the conclusion that these moral hazard distortions were one factor that contributed to the rapid expansion of mortgage debt over the last decade and attendant excessive price appreciation and risk taking. Granted, the real excesses, such as the subprime loans that everybody was initially discussing, came from MBS created by private institutions rather than the GSEs. But the stock market seems to be declaring pretty loud and clear this week that risks associated with enterprise assets are significant.

But some seem to have trouble with that notion.

However, the investors that really count have not yet weighed in. We along with others had thought that a successful sale of $3 billion of short-term debt by Freddie today would be an important sign of confidence, particularly since it was a doubling of spreads over Treasuries of agency two-year notes that was the latest warning signal that all was far from well in GSE-land.

However, we have also said that the powers that be would lean on anyone whose arm they could twist to show support for Fannie and Freddie and try to change psychology.

But one robin does not make a spring. John Jansen at Across the Curve (hat tip Mark Thoma) regards the results of Monday’s sale as irrelevant. The real test is whether repo traders are persuaded (note he wrote this before the Fed and Treasury statements were made):

One of the items mentioned in most of the stories is a previously scheduled Freddie Mac sale of $3billion of securities. Bloomberg suggests that the notes are short term and a quick check of the Freddie Mac home page informs the reader that the agency is issuing $2billion 3month bills and $1billion 6 month bills.

The various articles suggest that there is some concern or angst regarding investor support for that sale. The reports suggest that these sales will be an important test of investor sentiment regarding the GSEs. I think that the success of this sale will demonstrate very little. That amount of issuance is paltry and could be funded by Secretary Paulson himself and a dozen of his former colleagues at Goldman Sachs.

In my opinion, the canary in the coal mine for the agencies is the repo market. If large institutional suppliers of funds (money funds and sec lenders) shun agency debt as collateral for their lending, that will mark the beginning of a far more serious phase of the problem and would signal hard times ahead. So I will busy myself in the early trading tomorrow observing the movements in the rate at which agency collateral trades relative to government collateral.

Stay tuned.

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  1. lv


    I know that the bien-pensant position is to try and find cracks and problems with the gov. plans. But, it just may be the case that actually Paulson hit the problem on the spot. Without actually committing to anything, the Federal Government increased the explicitness of its implicit guarantee to FNM and FRE, and passed the ball to the (Democratic) Congress that WILL roll over (that is basically guaranteed). With that, how would any sane speculator bet against FNM and FRE? And if you cannot bet against, what does any sane speculator do? Definitely not stay on the sidelines and ponder the meaning of life, while sipping martinis.

  2. Steve

    [My last comment was clipped.]

    The real reason Bernanke set up separate borrowing facilities for non-banks is not “stigma”, but rather the statutory time limits on borrowings from the discount window. The Fed can roll these new style loans for as long as the Fed says the crisis is continuing.

    Some press articles suggest that the Fed needs Congressional approval to loan to the GSEs. This is not true. If some such thing is in the proposed legislation, that signals that a) some legislators are pissed at the Fed’s initiatives to date and b) that the Fed wants cover if it has to request authorization to balloon its balance sheet.

  3. Doc Holiday

    My fellow retarded American’s simply are missing the point with these piles of cash you write about here (that are adding up to numbers that have never been mentioned in our soap opera, before) — we hear problems with fannie, Indy and then related, yet new accounting issues with QSPEs and then this talk (rumor) about $5 or 10 thousand trillion, give or take this or that.

    Amazing, yet, no one gets it and I guess people are either numb or dumb, because I’m wondering what this costs per person, per year going forward in terms of future dilution. One should be thinking about future losses and the impact on future value, but for some reason, this matter eludes most everyone.

    As an example, recall this story, where the numbers and piles of cash are much smaller, but nonetheless to be paid for by taxpayers:

    Northern Rock will miss its target for repaying its £24bn emergency loan from the taxpayer if the housing market deteriorates further and the economy plunges into a 1992-style recession, it warned yesterday.

    The new executive team of the nationalised Newcastle-based bank told the Treasury select committee of MPs it would review its business plan this autumn. The plan, which involves halving the bank’s balance sheet to £50bn by 2011 and axing 2,000 jobs, is intended to repay the Bank of England by the end of 2010 and allow the government guarantee for depositors and creditors to be lifted by 2012.

  4. a

    It’s a fair question. If the housing market goes down another 20% over the next 2 years, then how much is this going to cost the American taxpayer? Will any of the powers that be answer the question (or something similar)? Rather than threatening us with the End of the World if we don’t get in line?

  5. Richard Kline

    So Steve, that is a good point of reminder, together with the fact that at the exigent auctions the Fed has more discretion on rates and collateral pricing. These are in effect, Because I Say So auctions.

    I find Paulson’s move to punt interesting, in an idle sort of way. This Administration has made a profession of opticals, but despite that I though just perhaps we would for the first time in seven years see someone in authority there active decisively in a crisis, even if the action was wrong. But no, Paulson stayed on form, miserable. It may be that the Treasury got legal advice it lacked statutory authority, but in the rare instances this Administration has dumped an issue on Congress it has invariably been an attempt to shift blame to the Democratic Party—and I suspect that is the real issue here. Paulson was overruled from acting, to my suspicions, because Dick or the Idiot want the assumption of the GSE debt to be realized by an act of a _Democratic_ Congressional majority. That allows Republicans to Blame Democrats for everything that goes wrong with it, and campaign from that position in subsequent election cycles. I don’t say that from a conspiracy standpoint but because this has been a crystal clear modus operandi of this Administration to this point.

    No issue, regardless of the level of crisis, escapes a partisan reflex by the present Administration. Ain’t it Grand?

  6. eh

    But what if it doesn’t?

    Absolutely no chance of that. Many Congresspersons seem like hopeless idiots. I wonder if they see anything wrong with people like Bill Gross saying he’s buying distressed GSE debt because he’s sure the government won’t let them fail/default. And don’t forget this is an election year.

    If the two companies fail, the mortgage markets could fall into tremendous disarray causing more write-offs at banks and making home loans much harder to get.

    Maybe the latter is exactly what’s needed?

  7. Anonymous

    be careful what you wish for…

    how much business is being taken away from the capital markets and put into the hands of the fed?

    can iBanks function without the gravy train underwriting business from the GSEs? and what about the repo market? how much is the fed cutting into that for banks when ibanks can cut out the middleman?

    the bandaid can only cover for so long until you need to expose the wound open in order for it to heal

  8. eh

    This post by Brad Setser makes it pretty clear that with respect to global financial markets any assistance to FNM and/or FRE without guaranteeing their debt is to say the least problematic, if not unthinkable.

  9. jopo

    one of the key issues that seems to be overlooked is the simple question of what will happen to the balance sheets of these two institutions. i can’t imagine that now that the fed and treasury are stepping in fannie and freddie will be allowed to expand their balance sheets further, at least in the short to medium term. this potentially means the housing market is about to get a whole lot worse. fannie and freddie were the only buyers left in the mortgage market…

  10. Anonymous

    “The Fed opens its discount window to Freddie and Fannie, which is an admission that there is a problem but not much of a solution, since the GSEs are certain not to use it (accessing the discount window is a kiss of death, seen an admission that a firm is desperate).”

    Oh, my. That is so old-school, grandpa.

    Cast your mind back to August 2007, when kind Uncle Ben opened the discount window and slashed the discount rate, in what was praised as an innovative response to the first inkling of financial distress.

    JP Morgan, B of A, Citi and Wachovia all stepped up to the plate for $500 billion each of discount window funding that they didn’t even need.

    Like gay marriage, discount window borrowing no longer carries any stigma. It’s ALL LEGAL, and the newly-minted borrowers can expect smiles and bouquets. Welcome to the window, Freddie and Fannie! How ’bout a round of applause for the cute couple?

  11. Dan Duncan

    This just came across the wires. Thought I’d pass it on….


    Treasury Secretary Henry Paulson just announced that the Federal Reserve has opened its “Discount Window” to Bob, an insurance salesman from Tampa, FL. [Editor’s Note: We are still in the process of confirming Bob’s last name. Will post upon confirmation.]

    Bob, who was interviewed on the steps outside of the Federal Reserve Building in Atlanta, GA, holding two fistfuls of cash, said, “Man, that Hank dude ROCKS! With summer vacation coming to a close in just about a month, we thought we were only going to be able to vacation in nearby Orlando. But with this,” Bob shows off his newfound bills, like a Pac Man Jones at strip joint, “we’re going to Cancun!!”

    When queried as to how he was able to access funds previously reserved for banks, Bob said, “Dude, it was so easy. I called the broker who had already hooked me up with the 3rd mortgage on my condo. He said he wasn’t doin’ loans right now, but that I should give Hank a call. So I did.

    “Wait a second. I think I still got one of his flyers…OH, yeah, here it is:

    ‘Need Ca$h Now?
    Call EAZY FED.
    Lot$ of ca$h
    Great Rate$ 2!!

    [At bottom of flyer is a buxom woman, holding a wad of cash. She’s smiling into the camera, and there’s a comic strip caption from her mouth which reads: “Oh Henry!!”]

    1-800-EAZY-FED. If you need cash, you should give him a call. He’s always working–even on Sundays.

  12. Risk Averse Alert

    Great stuff. Thanks for the insight.

    Personally, I believe GSE backing from the Bank of Abraham, Isaac, Jacob, Jesus and Mohamed would not change the fact the U.S. economy is structurally incapable of honoring its mountain of liabilities.

  13. Anonymous


    Example: Fed Report Update
    posted on July 11, 2008 11:59:22 am
    The Fed did an inconsequential net add of $1.75 billion today. That leaves the net drain on the week at $6.2 billion. The Fed continues to take no action to ease the extraordinary strain on the equities market. The Fannie-Freddie spread edged out to 91-95. Fed Funds rates were little changed and repo rates were….

    I don’t how tracking repos is possible with them being so obscure to examination or you can only see what they want you to see.

    Good Luck

  14. Steve

    richard kline,

    While I share your sense of Paulson’s shortcomings and fan-dance methods, I do think he acted decisively on the GSEs, even lining up Congressional support beforehand (although I doubt Treasury will get a completely free hand in mailing a check to Fannie and Freddie).

    The political choice that Americans don’t want to face is between dramatically shrinking the GSE mortgage market, with an attendant deflation in house prices, and directly subsidizing it, eventually at the expense of other discretionary goverment programs (when the national debt and erosion of the USD become intolerable to our foreign financiers).

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