With Fannie and Freddie, the US Is Bailout Nation

(2 of 2)

As the world's biggest debtor, the U.S. can ill afford to develop a reputation for stiffing its creditors, the reasoning went. Rates might rise sharply not just on mortgage securities but for all kinds of U.S. debt, including Treasuries. Such fears say a lot about this country's newfound financial dependence. So does Paulson's preference for making announcements on Sunday--just before the markets open for the week in Asia. "I suspect this is the first case where foreign central banks exercised their leverage as creditors to push the U.S. government to make a policy decision that protected their interests," wrote Brad Setser, an economist at the Council on Foreign Relations who closely tracks capital flows. One suspects it won't be the last.

Of course, by extending a taxpayer guarantee to $5.3 trillion in mortgage debt, Paulson and Congress do risk sparking global worries about the U.S. government's ability to service its debts. But so far, such concerns, while raised occasionally in the financial media, have had no discernible effect on interest rates.

About 80% of Frannie's debt securities remain in the U.S. The PIMCO Total Return Fund, the biggest bond mutual fund, had its best day ever the Monday after the announcement, rising 1.32%. Fund manager Bill Gross had put two-thirds of its assets in mortgage-backed securities while using the bully pulpit of his widely read monthly commentaries to call for bolder action to help housing. He got his way.

4 | What will this cost me? You and your fellow U.S. taxpayers are now formally on the hook for up to $200 billion in guarantees to Fannie and Freddie. That figure doesn't actually mean a whole lot--if housing prices begin to stabilize, Treasury could turn a profit on the deal; if the meltdown accelerates, it might not stop at $200 billion.

"I've been telling people that it's way too soon to estimate this," says Bert Ely, a financial consultant based in Alexandria, Va., who delivered some of the most accurate estimates of the cost of the savings-and-loan crisis of the 1980s. The S&L experience is instructive: the cost estimates started low (Ely's first guess was $25 billion), then eventually grew to $500 billion. The actual price tag, as calculated by the Federal Deposit Insurance Corp. (FDIC) long after the fact: $123.8 billion, or about 2% of annual GDP during the bailout years. That's equivalent to $286 billion today.

It's not just Frannie we're talking about here. There were also $29 billion in government loans behind Bear Stearns' shotgun marriage to JPMorgan Chase & Co. in March, although since they were made by the Federal Reserve--which can print its own money--it's not a direct cost to taxpayers. Then there are the $4.5 trillion in bank deposits insured by the FDIC. The first big bank bust of the current crisis, that of mortgage specialist IndyMac, cost an estimated $8.9 billion, leaving the FDIC with just $45 billion on hand to cover a likely rash of failures. But while the agency may hit up taxpayers for a loan, this would eventually be paid back with interest by surviving banks. "It becomes an issue only if the banking industry can't pay the bill," says Ely. If things get that bad, duck.

5 | What should happen to Fannie and Freddie now? After the savings-and-loan industry imploded, Fannie and Freddie filled the resulting vacuum to become the country's dominant providers of mortgage funding. Earlier this decade, though, Fannie and Freddie were caught cooking the books and punished by regulators with restraints on their growth. Meanwhile, Wall Street firms began buying and securitizing hundreds of billions of dollars in subprime loans too dodgy to meet Frannie's underwriting standards.

At the height of the housing bubble, from 2004 to 2006, the market share for GSES shrank toward the single digits. So if you're looking for a culprit for the bubble and bust, Frannie really isn't the best candidate. In one recent paper, three California real estate scholars even argue that it was in fact the absence of Fannie and Freddie and their reasonably tight underwriting standards that caused the bubble.

Whether you believe that or not, it's certainly true that Frannie has since stepped up precisely as private lenders have pulled back. Paulson's takeover plan envisions the GSES continuing to step up through the end of 2009, after which Treasury's backing expires and the next Administration and Congress will decide the companies' future.

As that deadline approaches, expect a fierce debate about the government's role in the housing market. Critics argue that Fannie and Freddie have become misshapen monsters, getting rich off implicit government guarantees. Yet when Wall Street managed to supplant them by backing subprime mortgages, the result was disaster. It's enough to make even the experts scratch their heads and wonder.