Monday, 14 July 2008

The Freddie and Fannie bailout begins

It was inevitable. On Sunday evening, the US Treasury announced a rescue plan for the two mortgage giants - Freddie Mac and Fannie Mae. It was simply inconceivable that the two institutions could fail.

The plan has three components:

A liquidity injection: - The US treasury will provide a line of credit to Freddie and Fannie.

Partial nationalization: - In order to provide additional capital, the treasury will be granted temporary authority to purchase shares the two GSEs. This sounds a lot like a limited rights issue.

Regulatory reform: - In future, the Fed will keep Freddie and Fannie on a tight leash.

In the short run, these measures will probably stabilise the share prices of the two institutions. Long term, the measures will be horrifically expensive. It will also prevent the GSEs from helping revive the US housing market.

Since the Treasury doesn't create dollars (the Fed does that) the liquidity injection will require the US treasury to issue debt. Likewise, the share issue will also require an increase in public sector debt. Since Freddie and Fannie are probably insolvent, the US treasury will have to kiss goodbye to billions.

The regulatory reform, if effective, will restrict the activities of Freddie and Fannie. Both institutions played a central role in the mortgage market, shifting illiquid mortgage contracts from retail banks to wholesale investors.

In the process, far too much housing market risk ended up on the balance sheets of the two institutions. Effective regulatory reform will seek to reduce these risks, and return it to the retail banks. This repatriation of risk will ultimately reduce the mortgage approvals, tighten lending standard, and raise mortgage rates. This will do nothing to stabilize US house prices.

The US housing bailout is now congealing around three initiatives; save Freddie and Fannie, insure subprime loans, and cover retail deposits via the FDIC. The bailout won't stabilize US house prices, but it might save the US financial system. The cost of this rescue plan will be enormous.

Other blog posts on the Freddie and Fannie bailout

Nakedcapitalism
Housingpanic
Mish
Calculated risk
Dr. Housingbubble
Blown Mortgage
Infectious Greed

6 comments:

Anonymous said...

If only we could turn back the clock back to 2004.

Anonymous said...

This is simply transfering the cost of failure from the investor to the taxpayer. It will not reboot the system, and like you said it will not reblow the housing bubble.

No such thing as a free lunch, so watch what it does to long term treasury rates.

Nick

Mark Wadsworth said...

So they are going for a Japanese long-drawn-out solution. Ah well.

Budvar said...

Let's see now, over the week end we have Indymac go tits up and fanny and freddy are both really up shit creek.

So what happens this morning as the exchanges open? The USD index is up 30 points and gold drops 10 bucks!! All we need now is for Gordon the unelected to get back from a meeting with Imadinnerjacket waving a piece of paper extolling the virtues of "Peace in our time".

Anonymous said...

I agree with Nick above - and just how great is the injustice to the taxpayer?

The Fed lends money at low rates to Fanny and Freddy, in order to save the guarantees on mortgages charging a much higher rate because of 'risk', when there is no risk.

Even the householder who bought out of necessity several years before the top of the bubble will watch his house decline in value, and pay a stiff mortgage under threat of eviction, while his taxes help out profligate borrowers who manage to survive and lenders who endure no risk

This reveals the taxation system in the US version of democracy as intrinsically immoral. It really stinks - as one Senator said, capitalism for the poor, socialism for the rich.

B. in C.

Anonymous said...

Budvar,

The bulltards are still fighting it out and choosing any news whatsoever as a reason to buy. Add in to that all the socialist market intervention (Bear, Freddie, Fannie and soon-Lehmans bailouts, tape-painting, discount window opening etc) and its clearly a good idea to stay the hell away from it all. Even the smart traders are losing their shirts (Buffet and Soros both down about 5% for the year).

Nick