The Treasury has proposed to Congress that it be granted “temporary” authority to extend virtually an unlimited line of credit to Freddie Mac and Fannie Mae and to also purchase their equity. Additionally, the Federal Reserve Board has also granted authority to the Federal Reserve Bank of New York to provide them access to the discount window at the primary credit rate.
These actions, while intended to be temporary and to enable these institutions to continue rolling over their outstanding debt and maintain their active role in mortgage markets, effectively amount to de facto nationalization of these two entities. Far from being temporary, these actions change forever the links between Freddie and Fannie and the government. This conclusion holds in spite of the fact that no loans have yet been extended, nor has equity been acquired.
The very fact that Treasury and the Fed have put in place mechanisms to ensure that these two institutions will survive has already enabled them to raise funds and has resulted in stockholders’ shares remaining at positive values. This result reflects the value of converting an implicit government guarantee into an explicit taxpayer guarantee, with all the problems and risks to the taxpayer that it entails.
Secretary Paulson has indicated that the terms surrounding any injection of funds would be designed to protect the US taxpayer. How this would be done seems to have been left purposely vague; but simply purchasing equity or preferred stock without additional rights, preferences, and warrants won’t cut it. Furthermore, it is now clear that the taxpayers are already explicitly at risk and will have to absorb losses should these entities fail.
Thus, taxpayers need to have those protections put in place immediately, even if equity is not purchased by the Treasury.
The key question is, what kinds of protections should be instituted? The Financial Economists Roundtable, a group of well-known senior finance experts, addressed this issue explicitly in a statement following their annual meeting in Glen Cove, NY earlier this week. They articulated the principle that the government should be “fully compensated for the full economic value of its support…” and this should include, in the case of equity injections, the granting of stock warrants “… for converting its implicit guarantee of their liabilities into an explicit guarantee.”
But I argue that further short-run protections are also needed, regardless of whether equity is provided, because existing stockholders stand to gain any upside should Freddie and Fannie recover, even without the injection of taxpayer funds. What is needed now is a host of reforms, many of which are different from those being proposed by Treasury.
First, the government’s commitment should be explicitly recognized through the granting of warrants or rights so that the taxpayer can participate in any upside that may now result.