America, Too Big to Fail . . . Probably: The feds can bail out Fannie and Freddie, but who will bail out the feds?

Nicole Gelinas – City Journal

Copyright City Journal
16 July 2008
The taxpayers’ predicament over Fannie Mae and Freddie Mac is already grave enough. The Bush administration has asked Congress for a massive rescue package for the twin “government-sponsored” mortgage investors and insurers, and the Fed has announced that it will extend short-term lending to both Fannie and Freddie. Graver still, though, is the fact that the rest of the world of supposedly “high” finance is becoming more like Fannie and Freddie, with potentially disastrous consequences for the American economy and taxpayer.
What are Fannie and Freddie—and why should we care? The two behemoths sponsor about half of the nation’s home mortgages, mostly of the old-fashioned, fixed-rate variety. They’ve guaranteed three-quarters of recent mortgages since the credit crisis began, up from 40 percent a couple of years ago, when investors were so optimistic about housing prices that they didn’t find the guarantees necessary. These mortgage guarantees, as well as the companies’ borrowing to support their own investments in mortgages, account for virtually all of Fannie’s and Freddie’s $5.4 trillion in liabilities.
A trillion here, a trillion there, and soon you’re talking about real money—more than one-third of the annual gross domestic product, in fact. Yet this mass of obligation sits on a razor-thin base. Fannie and Freddie hold only about $80 billion in actual capital, or under 2 percent of all of those potential liabilities. They get the rest of their money through borrowing. And because their borrowing matures regularly, they must raise new billions every month.
What this precarious capital structure means is that Fan and Fred have scarily little room for error. If the value of the mortgage loans they hold or guarantee declines by just a few percent, their capital is wiped out. William Poole, former chief of the St. Louis Fed, helped set off a run on the firms’ shares last week by noting that Freddie was already technically insolvent, thanks to the decline in home values over the past two years (though the situation had been clear in May). Why did lenders and shareholders, then, give such dangerous companies money to play with, especially on Fan’s and Fred’s customarily cheap terms?
The answer is that while Fannie and Freddie are technically private firms, their debt has come with an implied government guarantee. Everyone has long believed that Fannie and Freddie are “too big to fail”: that is, that the feds would never let them fall into bankruptcy, for two reasons. One, they’re crucial to the nation’s mortgage markets, partly because it’s hard for other firms to compete with their once-implicit government backing. Two, they’re crucial to the nation’s broader financial markets, having wrapped themselves in a web of guarantees, insurance contracts, and derivatives that makes Bear Stearns’s business look as straightforward as a lemonade stand.
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