Felix Salmon

Justin Fox asks for his readers’ questions about the Frannie bailout. Since I’m in a more-questions-than-answers mood today, I’m happy to oblige:

• Fannie Mae and Freddie Mac are still publicly-listed companies. Does that mean they’re still owned by their shareholders, and that unless and until the government actually dilutes those shareholders, management has a responsibility to work for the companies’ actual owners, like Bill Miller?
• Why did Paulson choose to shelter the owners of Frannie’s subordinated debt?
• Are Frannie’s obligations now part of the US national debt? Will they be, if and when the US government becomes 80% owner of the companies?
• What is the difference between Frannie debt now and Frannie debt on Friday? Is there more of a government guarantee than there was? Is there any credit risk in Frannie debt? Does that credit risk explain the spread between Frannie debt and Treasuries?
• Is there option value to either Frannie equity or Frannie preferreds? How do you value a preferred share which isn’t paying dividends? Who’s buying this stuff, and why?

Feel free to add your own questions (or, better yet, answers) in the comments.

Andrew Ross Sorkin today says there’s a relatively simple reason why Fannie and Freddie were forced into conservatorship: they needed fresh capital, but Hank Paulson essentially prevented them from raising any.

According to this theory, Fannie and Freddie would have been capable of raising money on their own — but then Paulson went and announced that he might (possibly, maybe, hopefully not) intervene with government cash. And as anybody who saw what went down at Bear Stearns knows, when Paulson intervenes, he intervenes with a vengeance, and shareholders are left with essentially nothing.

So on top of the normal risks of injecting new capital into leveraged entities with trillions of dollars of housing exposure, there was an extra political risk that all that capital could be wiped out at any time by an executive decision at 1500 Pennsylvania Avenue.

Writes Sorkin:

For the last two months, Fannie and Freddie ran around Wall Street searching for a savior. Private equity? Sovereign wealth funds? Anyone?

But Wall Street was never really sure what Mr. Paulson would do — and that was a problem. “He never laid out a roadmap and how he would use the power. Because of the uncertainty nobody was willing to put in money” into Fannie or Freddie, said Doug A. Dachille, the chief executive of First Principles Capital Management.

Sorkin for one is skeptical that there was any real emergency, and even hints that Paulson’s decision was political in nature:

Many people in financial circles can’t quite figure out why Mr. Paulson, the former chairman of Goldman Sachs, pulled the trigger when he did. He insisted politics had nothing to do with it. Never mind that the news broke just after the Democratic and Republican conventions, but as far away as possible from the November election.

But as of last week, Fannie and Freddie, for all their troubles, seemed to be bumbling along O.K.

I’m a bit more well-disposed towards Paulson. Clearly, if you are going to intervene, it’s better to do it sooner rather than later. Equally clearly, the management at both companies was something of a shambles, led by lobbying efforts rather than internal strength. And in any case the equity in Frannie was so tiny that it just didn’t make sense any more to run the companies for the benefit of shareholders.

Sure, Paulson might have held off on intervening while the conventions were going on. But the neither-one-thing-nor-the-other status of the GSEs was untenable, and he ultimately simply did the necessary thing. What’s more, I’m glad that it was Paulson doing it, rather than someone like John Snow, who would probably have let things deteriorate much further before pulling out his bazooka.

Dean Baker is right that the failure of Fannie and Freddie was due to the incentives that being private corporations gave them to take excess risk.

In the future, Fannie and Freddie can best serve their role of providing the stable anchor of the secondary mortgage market by being boring government corporations.

But I think he goes too far when he blames the whole bubble on Frannie.

If Fannie and Freddie had begun to tighten credit five or six years ago, when house prices were already clearly out of line, they could have stopped the growth of the bubble before it reached such dangerous proportions.

I’m not sure what he means by "tighten credit" here, but he certainly seems to imply that sans Fannie and Freddie the bubble wouldn’t have expanded so far:

Perhaps the private sector would have created a secondary mortgage market on its own, but it didn’t. Furthermore, private issue mortgage backed securities have performed far more poorly in the current crisis than the securities issued by Fannie and Freddie.

The problem with this argument is that the property bubbles in countries without Fannie and Freddie — Ireland, UK, Spain, South Africa, you name it — were even bigger than the property bubble in the US. Given US monetary policy, global liquidity conditions, and a society obsessed by home ownership, a bubble was going to happen, Frannie or not.

File under "strange bedfellows": over the weekend, both the Observer of London and Jim Cramer published desperate calls for the government to intervene to prop up the housing market.

The Observer’s is the one with the weakest logic:

The financial system today has no spare capacity with which it can weather the storm. The banks raised money for their loans not by attracting savings, but by borrowing on international markets using mortgages as collateral. That trade was worth around ߣ110bn in the year up to July 2007, when it abruptly stopped as the risks became obvious. But banks are still obliged, just as homeowners are, to repay their creditors.

Er, no. Mortgage-backed securities are backed by mortgages, not by banks. (The UK has very little in the way of covered bonds, which do have recourse to the bank.)

Meanwhile, Cramer’s decided that Hank Paulson should essentially write a blank check to anybody with housing equity:

The only hope to break the chain of despair and turn around the endless declines in home values to the point where you SHOULD walk away from a home with a mortgage larger than the value of your house, is to stop this house-price depreciation…

Once mortgage paper packaged by the government enterprises is federal government paper, then ANYTHING can be worked out with the borrowers, and the borrowers represent the lions’ share of the troubled homeowners in the country who have not already defaulted.

The government can cut the mortgage payments, and it can extend the terms, say to 45 years. It can take any hit to keep you in your home, and the paper is still insured.

Hey, I’d like to restructure my mortgage loan into a zero-coupon perpetual, do you think you could work that out for me, Mr Paulson? Thanks.

The fact is that the government has no business intervening in the housing market in the first place, unless it’s subsidizing housing for low-income families. And it has even less business trying to keep house prices at ridiculously inflated levels at a time when the market finally is coming to its senses.

If Cramer wants the Treasury to embark upon a massive fiscal stimulus, I can think of a couple of hundred alternative ways of spending the money which would be far more effective than trying to prop up homeowners’ equity. And the same is true in the UK. By all means, if the economy is spiralling into recession, go ahead and spend some money. But do it where it will have the greatest effect, not where it will simply perpetuate the very problem which caused the crisis in the first place.

(Thanks to Matt for pointing me to the Observer leader.)

The NYT talks today of "Mr. Paulson’s long-term desire to wind down the companies’ portfolios, drastically shrink the role of both Fannie and Freddie and perhaps eliminate their unique status altogether". It’s not a bad idea, and I like the way he’s going about it: let them increase their portfolios modestly from now until 2010, and thereafter force them to downsize dramatically.

They say that reforms only come in a crisis, never during the years of plenty — but in this case the marginalization of Fannie and Freddie during the housing boom would probably, on net, have been a bad thing. Insofar as anybody was sticking up for old-fashioned underwriting standards, it was the GSEs, and I suspect that if they hadn’t been around, prime underwriting would have suffered the same race to the bottom as subprime.

So what will the world look like once Fannie and Freddie shuffle slowly off the stage? Richard Green says that their great achievement was "the transfer of interest rate risk from households to investors" — which is indeed a clever and useful thing to do. And the absence of US-style high loan-to-value fixed-rate mortgages elsewhere in the world, even in countries with well-developed mortgage securitization apparatuses, would seem to imply that if and when the GSEs aren’t around any more, those cheap fixed-rate mortgages won’t be around either. Sure, you’ll be able to get a fixed rate — but you’ll pay for it with a significantly higher interest rate than that available on a floating-rate mortgage. And as a result, the fixed-rate mortgage won’t be nearly as common as it has been until now.

In the meantime, however, the agencies will continue to operate — and Nouriel Roubini, for one, is most unhappy with the structure of the bailout. I agree with this:

While not hitting the unsecured debt holders may have made some sense (as a lot of the agency debt is held by foreign central banks, sovereign wealth funds and other investors who would have fled the agency market if they had been subject to a haircut) not touching the subordinated debt of the GSE makes no sense; that is another additional bailout of a category of agency creditors that adds to the fiscal cost of the bailout.

I’m a bit unclear on who exactly owns Fannie and Freddie’s subordinated debt, but I suspect a lot of it is in the US banking system, and wiping it out could have had a much harsher effect on that system than simply imposing a haircut on preferred shares. Still, if you’re going to add to the fiscal cost of the bailout, then it’s always preferable to do so in a truly transparent way: make the sub-debt holders take some pain, and then bail them out if necessary.