• Cover Story
• Table of
  Contents
• Contents By
  Topic
• Columns
  • Brownstein
  • Cook
  • Crook
  • Powers
  • Rauch
  • Stokes
  • Schneider
  • Taylor Jr.
• Regular
  Features
  • Hotline Extra
  • Inside Washington
  • Insiders Poll
  • K Street Corridor
  • People
  • The Week on the Hill

The Treasury Department's "vast plan" to save Fannie Mae and Freddie Mac, as Monday's headline in The New York Times put it, was apparently not vast enough. Wall Street's instant reaction to the announcement from Treasury Secretary Henry Paulson Jr. was to drive shares of the two big lenders--pseudo-private agencies that own or guarantee nearly half of the mortgages in the United States--to new lows. This latest twist moved the lenders to the fore in the country's still-unfolding financial and economic drama, and they show no sign yet of moving aside.

This new prominence must feel strange. Until recently, Fannie and Freddie had maintained low profiles, given their amazing scale and the centrality of their operations to the housing mess that is dragging the economy

down. Their combined housing-loan book--mortgages, and guarantees of mortgages and mortgage-backed securities--is worth a staggering $5 trillion (equivalent to more than one-third of the economy's entire annual output). Over the years, some experts voiced concern about their management, their ambiguous status, and the regulations under which they operated. Little was ever done. Finally, Fannie and Freddie have made the front pages.

The pair are part of a complex, spontaneously evolving, and partially disguised system of government support for homeownership--probably the most generous system of its kind in the world.

The most visible element of this support was virtually unlimited tax relief for mortgage borrowing. The deliberately uncertain status of Fannie Mae and Freddie Mac was a subtler tool, but probably an even more important one.

The two agencies operate under congressional charters--and are called government-sponsored enterprises--but they are owned by their private shareholders. Until last weekend, Treasury and Federal Reserve Board officials insisted that the GSEs' debts were not public debt and that the government did not guarantee them.

Yet financial markets took it for granted that a de facto government guarantee was in place, and that assumption allowed the agencies to borrow cheaply. They used those borrowings to buy or underwrite mortgages and mortgage-backed securities. The implicit subsidy provided by the (officially denied) public guarantee was shared, in effect, among mortgage borrowers (who got better terms than they otherwise would), the enterprises' employees and shareholders, and financial markets at large--because, with Uncle Sam shouldering the financial risk in this way, private lenders felt free to be more adventurous.

Fannie and Freddie actually invented mortgage-backed securities, and played a vital part in developing and extending the market for these instruments. Securities that bundled together pieces of subprime and otherwise risky mortgages, for sale to credulous investors, were a later refinement, however; they were not Fannie's and Freddie's doing, not part of the original blueprint. Still, give credit where it is due (forgive the expression): Fannie Mae and Freddie Mac created the technology and then backstopped the risk when others pushed it up to, and finally beyond, prudent limits. The GSEs are implicated up to their elbows in the subprime meltdown.

Another aspect of their ambiguous status was the way they were--or more precisely were not--regulated. When a lender has losses, it needs capital to absorb them. Fannie and Freddie, however, were allowed to maintain thin bases of capital for their operations. For months, the agencies' shares had been falling because of fears that losses on their loans were eating up those reserves. Those worries crossed a psychological line last week, and Wall Street began to contemplate the agencies' insolvency.

It seemed--and still seems--inconceivable that the government would stand aside and let these enterprises fold. Washington wants to prop up the housing market by supporting the flow of new mortgage finance; it wants Fannie and Freddie to play a bigger role, not a smaller one. If they simply collapsed, the effects on housing prices and consumer confidence would be unimaginably dire. However, a government rescue of Fannie and Freddie would not necessarily bail out the stockholders. (Ask Bear Stearns's shareholders how that works.) Hence the panic selling of the GSEs' stock last week--and again this week, even after Treasury's vast new initiative.

The truth is, it was an initiative of uncertain size. Treasury asked Congress for permission to extend a bigger credit line to the agencies and to buy equity in them (that is, supply new capital) "if needed." Paulson also proposed--you guessed it--better regulation. And the Fed announced at the same time that, if necessary, it would extend temporary liquidity support to the agencies, which it can do without congressional approval.

As this column went to press, Congress had not approved Treasury's requests, though the initial response, especially among Democrats, was favorable. Sen. Jim Bunning, R-Ky., was among the scandalized minority. When he picked up his newspaper earlier this week, he said, he thought he had "woken up in France." The horror.

Even assuming that Congress gives Treasury the powers it has asked for, you can bet that Washington will try to avoid bailing out Fannie and Freddie at taxpayers' expense. Depending on what happens, the possible outcomes range all the way from no further Treasury action to outright nationalization of the agencies--an option that would give a whole new meaning to "big-government conservatism." Neither of those extremes seems likely: Circumstances will rule out the first, and politics the second.

Over the coming days, Treasury and the Fed will likely just muddle through--trying, as always, to have it both ways.

The Bush administration will affirm that the GSEs are not publicly guaranteed, and it will pledge that they will stay privately owned and get the funds they need. That will likely mean ad hoc injections of taxpayers' money--potentially large amounts, if the agencies' losses grow. But no overt takeover, just a stronger regulator. Given the political difficulties, my bet is that the mortgage lenders will retain their ambiguous standing unless some as-yet-unimagined catastrophe forces the administration's hand. And that is a pity, because this ambiguity has been an important underlying cause of the current distress.

If the housing market were not on its knees, Washington could contemplate an orderly restructuring of Fannie's and Freddie's liabilities as an alternative to outright nationalization. Lenders to the GSEs would be forced to accept a write-down in the value of their loans to the agencies, or else a lower interest rate, just as the creditors of any ordinary bankrupt company or country would expect. Shareholders would go to the back of the line for any residual value in the agencies.

This restructuring would have the great virtue of sparing innocent taxpayers any outlay. But unfortunately, as you probably noticed, the housing market is on its knees. If it weren't, the agencies would not be losing money and would not need supporting. And we would not be having this conversation. A methodical restructuring of this kind, though fairer and more efficient in one way, would surely cripple the agencies' ability to support new mortgage lending here and now, a huge risk for the government to take. If Washington plays it safe, and makes the continuing operations of the agencies its top priority, taxpayers will end up footing most of the bill.

An imminent turnaround in the housing market would help on this and many other fronts, of course. How likely is that? Unfortunately, not very. On July 15, Fed Chairman Ben Bernanke delivered his semi-annual report to Congress, and it makes gloomy reading. "In the housing sector," he reported, "activity continues to weaken.... Sales of new homes have continued to fall.... In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling.... The declines in home prices have contributed to the rising tide of foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn, intensified the downward pressure on home prices in some areas."

If no break in the trend of rising foreclosures and falling housing prices is yet visible, Fannie's and Freddie's losses are likely to keep mounting. The problem is not going to fade away on its own.

Meanwhile, the Fed has other problems on its mind as well. Rising prices for oil and other commodities, and the continuing weakness of the dollar, are pushing inflation up. On balance, the dollar's weakness is helping the economy, because it is boosting exports--almost the only good news in the economic data just now. But a cheap dollar worsens the Fed's dilemma because it makes imports more expensive and adds to the risk of inflation.

With the economy so weak, and the financial system so stressed--as was underlined last week by the failure of IndyMac Bank, with other bank collapses in the pipeline--the Fed would prefer to keep cutting interest rates. But the economic slowdown is happening alongside strong and unusual upward pressures on prices that the Federal Reserve cannot ignore.

In all, Bernanke said, the Fed sees the risks as "skewed to the downside." Yes. It sure feels that way.