A Darker Outlook at Fannie and Freddie

[Woodmonkey]

Shareholders of Fannie Mae and Freddie Mac, the big government-backed mortgage companies, were hammered anew last week, as the companies reported worse-than-expected quarterly results and warned of more pain to come. For all the distress, no one should be surprised that shareholder value has been destroyed.

At Fannie and Freddie, as at other financial firms, highly paid executives stoked profits during the housing bubble by piling into loans and mortgage-backed securities that were bound to tank — unless house prices rose forever and the economy never soured. Their higher quality assets, being mortgage related, also made them vulnerable to a housing downturn. In addition, the companies have been poorly supervised — by lawmakers who put a higher value on campaign contributions than on their duties, and by federal regulators who failed to stop the bad lending that fed the bubble.

The question now is whether taxpayers will have to bail out the companies and, if so, whether the government is committed to protecting taxpayers’ interests.

Under a law signed by President Bush in July, the government has the authority to use taxpayer dollars to rescue Fannie and Freddie from insolvency. That authority is necessary because the companies are essential to the credit and housing markets. Even the perception that they might fail could derail the financial system.

But it is still unclear what the Bush administration has in mind if direct intervention is needed. The administration hopes it never has to use the new power, that the mere existence of a government backstop will bolster investor confidence, enabling the companies to raise capital from private investors.

The more the companies weaken, however, the less likely investors are to step up and the more likely it is that any government intervention would be substantial.

In that event, taxpayer interests must come first. That implies wiping out the shareholders, so that available cash goes to taxpayers and their claims on the value of the companies take precedence. It should go without saying that taxpayer money should not be used to prop up private shareholders.

But in his desperation to avoid a bailout on his watch, Mr. Bush has implied a willingness to do just that. At a recent news conference, he indicated that as long as shareholders owned Fannie and Freddie, the government’s new authority could not be deemed a “bailout.”

A government rescue would also require firing the current management — a bailout being the ultimate sign of managerial failure. The government would have to take control of Fannie and Freddie until the housing crisis passed, and then debate how best to sever the links between the government and the companies. The risk to taxpayers is too great to allow them to continue in their current form.

A parallel debate must also occur about how the government should be involved, going forward, in fulfilling the companies’ original mission: to ensure that underserved groups have access to mortgages and that low-income housing needs are met.

Fannie and Freddie may yet muddle through without an explicit bailout. Their near-death experience seems to have wised them up. For instance, they are now putting a greater effort into modifying the mortgages of hard-pressed borrowers.

But there is no return to the old normal. The future of Fannie and Freddie will be different from their past.

The Source