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