Fannie/Freddie Bailout: The Socialization of Mortgages?

According to the Wall Street Journal, there is a deal imminent for a bailout and possibly a restructuring of both Fannie Mae and Freddie Mac. So far, from what I have been able to read, this restructuring deal is terribly troubling. Here are some of the most important things that the Journal reports.

The plan is expected to involve putting the two companies into the conservatorship of their regulator, the Federal Housing Finance Agency, said several people familiar with the matter. That would mean the government would take the reins of the companies, at least temporarily.

It is also expected to involve the government injecting capital into Fannie and Freddie. That could happen gradually on a quarter-by-quarter basis, rather than in a single move, one person familiar with the matter said.

In addition, Treasury's plan includes a top-level management shakeup at both companies, according to people familiar with the plans. Daniel H. Mudd, chief executive of Fannie Mae, and Richard Syron, his counterpart at Freddie Mac, are expected to step down from their posts eventually.

Effectively, what this means is that for the indefinite future the mortgage market has been effectively socialized. At this point more than 99% of mortgages are underwritten by either Fannie Mae, Freddie Mac, or FHA. FHA is already part of the government and now so will both Fannie and Freddie. It's important to understand that Fannie and Freddie don't merely securitize loans, but they underwrite them and their bonds set the rates for them. Now, all of these functions are going to be done by the government. Now, of course, the Feds say that this will only be temporary, but there is no timeline or future plans beyond the nationalization of these mortgages. As such, for the time being, the entire mortgage market is socialized.

I am extremely worried that the Feds think that a house cleaning of the top level management is a solution in and of itself. It isn't. I have no love loss for the management, however both these giants have had several different administrations over the last ten to fifteen years and all of them have been far too corrupt. For instance, Fannie went through an accounting scandal four years ago and it forced th resignation of their top managers.

This has not yet impacted the stock price for Fannie Mae, but Moody's and Standard and Poor's have downgraded some of Fannie Mae's subordinate debt. Given the large percentage of the American economy that is tied up in housing values, a major scandal involving Fannie Mae could be highly damaging to investor confidence.

However, Freddie Mac was able to overcome its summer 2003 scandal without serious damage.In December 2004, CEO Franklin Raines and CFO Timothy Howard
were forced to resign. The company also dismissed its auditor, KPMG.

In testimony given to the U.S. Senate Banking Committee in April 2005, it became clear that Congress, with support from all the parties, was planning to strengthen oversight of all the GSEs.

This accounting scandal was created under an entirely different regime than the current one. In fact, the current one was installed to root out the corruption of the last one. Here is what Politico recently reported about Fannie and Freddie lobbying..

If you want to know how Fannie Mae and Freddie Mac have survived scandal and crisis, consider this: Over the past decade, they have spent nearly $200 million on lobbying and campaign contributions.

But the political tentacles of the mortgage giants extend far beyond their checkbooks.

The two government-chartered companies run a highly sophisticated lobbying operation, with deep-pocketed lobbyists in Washington and scores of local Fannie- and Freddie-sponsored homeowner groups ready to pressure lawmakers back home.

The reason the two spent so much money on lobbying is because as Government Sponsored Entities they were private companies that were also extensions of the government. Now, they won't merely be extensions of the government but a part of it. This won't reduce lobbying pressure but increase it. Both Barack Obama and John McCain have each made intuitive statements about the two. Here is what Obama said.

Sen. Barack Obama, the Democratic nominee, has said the companies are a "weird blend" and that "if these are public entities, then they've got to get out of the profit-making business, and if they're private entities, then we don't bail them out."

Here is what John McCain said.

Sen. John McCain, the Republican nominee for president, has said his goal is to make the companies "go away" and to push for regulation that "limits their ability to borrow, shrinks their size until they are no longer a threat to our economy and privatizes and eliminates their links to the government." Sen. McCain supported giving Treasury the authority to backstop the firms but has said any use of taxpayer funds should be combined with an ouster of management and a ban on lobbying by the companies.

The problems of the two are obvious, and their solutions are in a sense simple. Obama is right that it absurd to allow them to be stuck in a nether world where they are both private and public. It is also absurd to allow there to be two companies to control the entire securitization market. Here is the rub. In order to straighten things out, it would require something called "restructuring".

Here is why restructuring is simpler to say than to do. Imagine if the government decided that our highway system was inefficient and they decided to "restructure". Now, imagine if the country woke up one day, and the entire highway system was reorganized. No route was the same. Now, if you were to go to work, you would have to find a new highway somewhere different than where you are used to. Let's even say that the new highway system is a lot more logical. In the beginning, there will still be total mass chaos. Can you imagine the traffic and confusion that would cause until everyone learned the new system. That's the problem with restructuring it now. Any sort of revolutionary mass restructuring will initially cause chaos. That's fine if the market isn't as weak as it is now. Right now, the market simply can't afford the hit that a restructuring would bring.

That is the sort of chaos that faces the mortgage market with this restructuring. First, these companies need to be privatized. Second, they need to be broken up and create five to ten new companies. Since these two control everything from underwriting to pricing to securitization, the entire mortgage market would be restructured at once. Imagine a mortgage professional used to working with the current Fannie/Freddie systems that would now work with all new systems. The new companies would have to create their own underwriting systems, and the market would need to figure out all new ways of pricing mortgages with a several new securitization companies in the mix. The problem is that these two are in desperate of the kind of top to bottom restructuring at exactly the worst time for the real estate market to face the sort of chaos that would initially cause. Thus, the entire industry is stuck between the proverbial rock and hard place. As it stands now, both have been bailed out and are now fully backed by the government. This is the ultimate moral hazard. Not only was their irresponsible behavior bailed out, but any future irresponsible behavior is now backed by the full faith of the U.S. Treasury. That is a recipe for even more irresponsible behavior.

In order to insure that both Fannie Mae and Freddie Mac have as little motivation as possible to continue with their irresponsible behavior, they must be privatized and broken up immediately. Yet, that sort of restructuring would send an already weak real estate market into a state of chaos. In other words, the two choices are bad and worse.