Treasury's bail-out logic

The Fannie Mae and Freddie Mac bail-out will impose needed reforms in their business practices. Ultimately, the cost to the taxpayer may not be large if the federal government gets Wall Street to help.

To recap on Sunday's announcement, Treasury has placed Fannie and Freddie under federal conservatorship and booted the senior management. It will buy some Fannie and Freddie bonds to shore up confidence that these are fully backed by the federal government, and it will make short-term loans to Fannie and Freddie. These pose little risk to the Treasury and will net profits for the taxpayers.

The Treasury will purchase up to $200 billion in preferred shares to provide capital to cover losses on defaulting mortgages. The initial purchases are $1 billion in each company, and total purchases could reach $50 billion over the next 18 months. In return, the Treasury receives a 10 percent dividend and warrants to purchase 79.5 percent of the common stock for less than a penny a share.
Until recently, Fannie and Freddie stuck to their mission – insuring and financing low down-payment mortgages to low and middle income families with good credit and income histories – and that was a profitable business. If housing prices stabilise, Fannie and Freddie should become profitable and an attractive investments again. The Treasury will be able to sell its common and preferred stock and may recoup most or all the money that it puts in now. Fannie and Freddie will also be able to raise new capital.

The real challenge is to assist private lenders to make certain that adequate mortgage funds are available to all qualified homebuyers and housing prices stabilise.

Fannie and Freddie account for about $5 trillion of the $12 trillion in outstanding mortgages. The balance was financed by commercial banks and mortgage companies.

Until recently, regional banks and mortgage companies did not fund most loans from deposits. They wrote mortgages and sold these to Wall Street banks and securities companies, like Citigroup and Lehman Brothers. Wall Street bundled these loans into bonds for sale to insurance companies, pension funds and other fixed income investors.

In recent years, regional banks and mortgage companies increasingly wrote sub-prime loans with potentially high default rates. Wall Street became quite skilled at dressing up bonds backed by dodgy loans with what proved inadequate default insurance. In the end, too many loans defaulted, foreclosed properties on the market swelled, and housing prices dipped. Bond holders took losses, and the big Wall Street financial houses mostly left the mortgage financing business.

Falling housing prices caused more of Fannie and Freddie's prime loans to fail. However, these companies also succumbed to the sub-prime frenzy by lowering their lending standards, which increased their losses. Federal supervision should fix that.

Wall Street banks and securities companies have quit securitising loans into bonds, as their executives have gone looking for other businesses that could create big profits and bonuses. The regional and mortgage must rely on deposits to write new mortgages, and those deposits are hardly enough. Currently, 90 percent of the new mortgages being written are Fannie and Freddie backed loans, instead of the historical 40 percent, and a general shortage of mortgage money dogs the housing market.

Fannie and Freddie, alone, cannot provide enough mortgages to put a floor under prices and provide for new home constructions. To play their part, regional banks and mortgage companies must again be able to sell loans to large fixed income investors through the Wall Street.

Citigroup, Lehman brothers and other Wall Street financial houses have their own problems, thanks to losses on sub-prime loans. The Federal Reserve has loaned them more money than the Treasury is putting into Fannie and Freddie but has not required much from them in return.

The Federal Reserve made loans on easy terms, because these Wall Street firms are considered "too big to fail” and provide vital banking services to the economy. However, Wall Street has taken the aid while cutting back on those vital banking services – they are not buying and securitising mortgages into bonds. Instead, they are emphasising other high-profit, non-banking activities, like wealth management, securities trading and mergers, and the economy suffers from a shortage of mortgages.

The Federal Reserve should require the big Wall Street financial to securitise mortgages into bonds in exchange for its loans. Only then, will the US have enough mortgage money to resurrect the housing market, ensure the vitality of Fannie Mae and Freddie Mac and get the economy going again.

Peter Morici is a professor of business at the University of Maryland and former chief economist at the US International Trade Commission