When is a bailout a bailout?
Financial markets underwent gyrations Monday after Barron’s reported the federal government would soon take over Fannie Mae and Freddie Mac. If you are thinking the government had already offered to bail them out, you are not alone.
But there are bailouts and then there are bailouts. The article in Barron’s, citing an unnamed Bush administration source, said the imminent federal move would effectively nationalize Fannie and Freddie, wiping out all the stockholders’ equity. Moreover, all top-level management would be fired.
That scared the financial markets. But for ordinary citizens and taxpayers, such a move would be much better than alternatives more palatable to Wall Street. It would establish a principle that private shareholders should lose every last cent before the Treasury kicks in even one thin dime.
That was violated in the Bear Stearns takeover, when the Federal Reserve handed over wads of cash in return for some $30 billion in securities of very questionable value. Yes, Bear Stearns’ stock price plummeted. But its stockholders kept some value, particularly after threats of lawsuits prompted J.P. Morgan Chase, the Fed-anointed acquiring firm, to sweeten its offer.
Fannie and Freddie shareholders would prefer similar government generosity. They would like the Treasury to buy up existing shares, raising the stock price, or to buy a new issue of shares, thus pumping in fresh capital to offset ongoing write-offs.
Or they would like a variation of Bear Stearns, with the Federal Reserve handing over cash in exchange for some of the dodgiest securities in Fannie and Freddie’s portfolios. Either way, they would duck the results of their managers’ imprudent policies.
Make no mistake about it, these government-sponsored entities’ problems are not the result of their following their original mandate of facilitating mortgage lending for middle- and lower-income households. Fannie and Freddie bought up more than $300 billion and $200 billion, respectively, of non-insured and risky Alt-A mortgages. This was to juice returns for their shareholders, not to give the poor greater access to housing.
One important distinction is that while shareholders should be sacrificed, Fannie’s and Freddie’s bondholders should be protected. That is, buyers of their mortgage-backed securities and other bonds should get the principal and interest they were promised. That is why these institutions were set up in the first place, to facilitate channeling private savings into home mortgage lending by giving an explicit or implicit government guarantee to Fannie and Freddie’s debt securities.
The big question is what the federal government should do with Fannie and Freddie once it takes them over. It should sell them off to private ownership again, but only after breaking them up into bite-sized pieces. Never again should the federal government encourage the existence of private but government-sponsored entities so large that two of them handle more than half of all mortgages.
As they exist now, Fannie and Freddie are so large that even if broken into 10 or more chunks each, the new businesses would still be major financial institutions. Such a breakup would be a healthy development.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.