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.
Second, the regulatory structure and oversight needs to be improved, including the granting of receivership authority to the responsible regulator.
Third, capital adequacy standards need to be tightened, a system of mandatory trip wires should be put in place to trigger mandatory regulatory interventions should capital ratios fall below critical values, and accounting standards need to be based upon market and not book or regulatory values.
Fourth, simply giving authority or new powers to a different regulator without also changing the underlying behavioral incentives and methods for ensuring accountability, means that reforms will be ineffective. Particularly important will be mandatory outside reviews and strict accountability and reporting on the financial condition of these institutions and any losses that may have to be absorbed by taxpayers.
Fifth, to deal with troubled financial institutions more generally, a crisis-resolution policy should be put in place for financial institutions, including Freddie and Fannie, that pose potential systemic risks to the financial system and economy. It should include bank-like receivership and resolution procedures expressly designed to minimize costs to the taxpayer. This would include the authority to create a bridge bank-like institution to acquire and run the entity should it be placed in receivership.
Sixth, serious consideration should be given to scaling back Freddie and Fannie’s activities to the mortgage guarantee business, since government financing of private mortgage debt will only drive out private sector lending activities.
Finally, since Freddie and Fannie primarily exist today because their GSE status enabled them to borrow at an advantage that could not be matched by private sector firms, efforts need to be made to reprivatize them. Since this didn’t work the last time it was done, and since the processes and markets for mortgage-backed instruments are sufficiently developed now, consideration should be given to breaking the two GSEs up and selling the activities off to private investors in ways that clearly and unambiguously sever the link between them and the federal government.
These suggestions, of course, ignore the political fight that would surely ensue, especially if Freddie and Fannie were to be broken up, because what will be perceived to be at stake here is the sacred cow of housing. All that notwithstanding, it remains the responsibility of Congress to ensure that, whatever Treasury does, adequate protections are in place to make good on the goal of protecting the taxpayer.