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Can the Bailout Work?

by PETER MORICI

The Treasury Department has placed Fannie Mae and Freddie Mac under federal conservatorship and booted the senior management. This bailout will impose needed reforms in the companies’ business practices. And, contrary to much conventional wisdom, the cost to the taxpayer may not be large – that is, if the federal government gets Wall Street to help.

The Treasury will buy some Fannie and Freddie bonds to shore up confidence that these are fully backed by the federal government, and it will make short-term loans to Fannie and Freddie. These pose little risk to the Treasury and will net profits for the taxpayers.

The Treasury will also purchase up to $200 billion in preferred shares to provide capital to cover losses on defaulting mortgages. In return, the Treasury receives a 10 percent dividend and warrants to purchase 79.5 percent of the common stock for less than a penny a share.

Until recently, Fannie and Freddie stuck to their mission – insuring and financing low-down-payment mortgages to low- and middle-income families with good credit and income histories. This was a profitable business. If housing prices stabilize, Fannie and Freddie should become profitable and attractive investments again. The Treasury will be able to sell its common and preferred stock and may recoup most or all the money that it puts in now. Fannie and Freddie will also be able to raise new capital.

The real challenge is to assist private lenders to make certain adequate mortgage funds are available to all qualified home buyers as housing prices stabilize. That’s where Wall Street comes in.

Fannie and Freddie account for about $5 trillion of the $12 trillion in outstanding mortgages. The remainder was financed by commercial banks and mortgage companies. Until recently, regional banks and mortgage companies did not fund most loans from deposits. They wrote mortgages and sold these to Wall Street banks and securities companies, such as Citigroup and Lehman Brothers. Wall Street bundled these loans into bonds for sale to insurance companies, pension funds and other fixed-income investors.

In recent years, regional banks and mortgage companies increasingly wrote subprime loans with potentially high default rates. Wall Street became quite skilled at dressing up bonds backed by dodgy loans with what proved inadequate default insurance. In the end, too many loans defaulted, foreclosed properties on the market swelled, and housing prices dipped. Bond holders took losses, and the big Wall Street financial houses mostly left the mortgage financing business.

Falling housing prices caused more of Fannie and Freddie’s prime loans to fail. However, these companies also succumbed to the subprime frenzy by lowering their lending standards, which increased their losses. Federal supervision should fix that.

Wall Street banks and securities companies have quit securitizing loans into bonds, as their executives have gone looking for other businesses that could create big profits and bonuses. The regional banks and mortgage companies must go back to relying on deposits to write new mortgages, and those deposits are hardly enough. Fannie and Freddie alone cannot provide enough mortgages to put a floor under prices and provide for new home constructions.

Regional banks and mortgage companies must again be able to sell loans to large, fixed-income investors through Wall Street. Citigroup, Lehman and other Wall Street financial houses have their own problems, thanks to losses on subprime loans. The Federal Reserve has loaned them more money than the Treasury is putting into Fannie and Freddie but – so far – has not required much from them in return.

The Fed made loans on easy terms because these Wall Street firms are considered “too big to fail” and provide vital banking services to the economy. However, the companies have taken the aid while cutting back on those vital banking services; they are not buying and securitizing mortgages into bonds. Instead, they are emphasizing other high-profit, nonbanking activities, such as wealth management, securities trading and mergers. Thus, the economy suffers from a shortage of mortgages.

The Federal Reserve should require the big Wall Street financial firms to securitize mortgages into bonds in exchange for its loans. Only then will we have enough mortgage money to resurrect the housing market, ensure the vitality of Fannie Mae and Freddie Mac and get the U.S. economy going again.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

 

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PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.

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