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Handicapping the Fannie Mae/Freddie Mac Situation

Whither Free Markets?

In the financial markets, last week was the wildest and most dramatic one since the Bear Stearns Companies collapsed last March. The subject was whether we would see a collapse of Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that together own or guarantee $5.3 trillion in US home mortgages.

And by extension, the fear spread to the entire US financial sector. The popular imagination was captured by the failure and seizure of IndyMac, a California-based bank with large exposures to the Alt-A and subprime lending markets. This event was not insignificant. But it was dwarfed by the huge amounts of value that were subtracted from the stock prices of financial companies across the spectrum, and that came roaring back by midweek.

Let’s give credit where it’s due: Treasury Secretary Henry Paulson gets plaudits for stabilizing the situation. I’ll explain shortly.

But the emergent theme is that we’re moving decidedly toward much greater government control over the financial system. The very idea of free markets took a big hit last week.

As I explained to you in several posts last week, the essence of the Fannie/Freddie situation was not that the GSEs are in any danger of collapsing and taking 10% of the total stock of US financial and real wealth with them. Even here at RedState, the blogosphere’s bastion of probity, we had some feverish commenters activating this ridiculous fear.

The danger with Fannie and Freddie was that their extremely thin equity cushion could be wiped out if losses in their mortgage portfolios accelerate in the next few years. This would put the GSEs at risk of regulatory noncompliance and endanger their ability to continue to raise the funds needed to extend mortgages to American homebuyers.

Some of the most frightening statements were made by William Poole, retired President of the St. Louis Federal Reserve Bank, who for years has been grinding an axe against the GSEs. He said about ten days ago that Freddie Mac could be considered insolvent today (in the balance-sheet sense of liabilities exceeding assets) if you marked their portfolio of mortgage-backed securities to market. Of course Poole didn’t mention that liquidity impairment and widespread risk aversion account for most of the reduction in the current market value of high-rated MBS. The credit risk of the GSE MBS portfolio is not any worse that it was two weeks ago.

Then, some analyst from one of the sell-side firms (I forget who) popped up to say that about $70 billion in new equity capital would be needed to reassure markets about the health of the GSEs.

Since you couldn’t raise $70 billion in equity these days even if you were prepared to go looking for it on Mars, many people decided that the sky was falling, and dumped GSE stocks as if they were Bear Stearns. That touched off the wild week.

The weekend before last, Secretary Paulson made some totally un-reassuring statements to the effect that A) the GSEs were indeed healthy enough and their continued operation was not at risk; and B) the Treasury Department would act aggressively to ensure the same.

And over the same weekend, Paulson’s people quickly drafted up an addendum to be attached to the pending Dodd-Frank Act (aka the “Foreclosure Prevention Act of 2008”), giving Treasury what amounted to carte blanche to intervene on behalf of the GSEs until sometime in 2009.

What Paulson wants is a Congressionally-preauthorized ability to put Federal (read, “taxpayer”) money into Fannie Mae and Freddie Mac at any time of his choosing, under any circumstances whatsoever.

Senator Dodd doesn’t really know what to make of this, which is not a big problem. Representative Frank (who, like him or not, actually has learned his way around the world of finance and is a very effective regulator) basically said that what Paulson is asking is fine by him, with one exception: any expenditures in support of Fannie and Freddie must be subject to the Federal debt ceiling.

Paulson had originally proposed that they be exempt. Frank was applying a political fig leaf with this. It isn’t a big problem, because the point of all this activity is not to bust the Federal budget. Hank Paulson would probably be surprised if he indeed needs to use his soon-to-be-approved statutory powers to backstop Fannie and Freddie.

Finance is all about being confident in the ability of the people you do business with to meet their commitments. In distressed times, like these times, it’s all too easy for rumors and stories to turn into panic. Observable reality tends to take a back seat. Paulson knows this as well as anyone, which is why he did what he did.

The net effect, in the eyes of market participants around the world, is that the government has now stated in so many words that the GSEs will not be allowed to fail. They have always enjoyed the patina of an (often-disavowed) implicit Federal guarantee, which has now been transformed into an explicit one.

And the effects of this were seen very clearly in last week’s market action. On Friday the 11th, spreads between agency (Fannie/Freddie) debt tightened considerably by comparison with US Treasury debt of similar maturity. But by midweek, spreads started expanding again to the (elevated) levels that have prevailed in recent months.

And on Monday and Thursday of last week, Freddie Mac priced two separate issues of 2-year bills, which were oversubscribed at the relatively low prices implied by the high market yields on already-outstanding agency debt of similar maturity. The auctions went off swimmingly, with the eager participation of foreign central banks.

Interpretation: markets were reassured by the newly-explicit Federal guarantee of agency debt, went back to looking at fundamentals, and saw a financial situation that hasn’t changed much. Nearly back to normal. Well, more precisely, back to the distressed conditions that have prevailed for more than a year in credit markets. But not panic.

It took Senator James Bunning of Kentucky, one of the most conservative people in Washington, to speak the subtext.

Early in the week, Paulson and Fed Chairman Ben Bernanke trotted up the Hill to testify in Congress. (Bernanke’s testimony was his regularly-scheduled update, but they spent a good part of his time on the GSE situation.)

In widely-publicized and angry remarks, some of which were unscripted, Bunning took both men to task, in essence for curtailing the freedom of the financial markets.

Some of what the Senator said was immoderate. For example, he told Paulson that the markets had passed a negative judgment on his GSE-rescue plan, because they had shaved nearly 30% off their stock prices that morning.

Paulson must have had to bite his lip to keep from retorting that he would have been happy to wipe out FNM and FRE shareholders, as a way of inhibiting future moral hazard. Just as he had insisted on murdering the shareholders of Bear Stearns back in March.

But Sen. Bunning’s point is extremely well-taken. If it takes swift, aggressive promises of government action to keep the world’s financial markets functioning in an orderly manner, then what, if any, is the role of market freedom? Bunning said memorably that, reading the newspapers, he felt like he had woken up in France.

Everyone has always accepted the need for markets. What is not universally accepted is that markets ought to be free.

The word “ought” in that sentence was carefully chosen, implying as it does an ethical or moral dimension. What actually happens is that the world goes through cycles in which markets are more or less regulated.

Back in the early Thirties, there was so much disillusion among Americans over the behavior of free markets (specifically in the banking system) that our great-grandparents saw fit to support the New Deal, which imposed tight controls over nearly aspect of American finance.

By the late Seventies, the defects of heavy market regulation were apparent enough to everybody that we signed up for massive de-regulation, culminating in the Gramm-Leach-Bliley Act of 1999, which completed the repeal of the 1933 Glass-Steagall Act.

Now, we’re set up for another round of heavy regulation. As we get into it, let’s remember a few things.

First: what do you give up when you walk away from market freedom? You give up efficiency. The aggregate productivity of a heavily-regulated financial system is axiomatically lower than that of a lightly-regulated one. This is not a matter of debate. We can debate whether we would rather have the benefits of heavy regulation, but I won’t let anyone argue that regulation makes the economy more productive (which Barack Obama implies when he says that he intends to create more high-paying jobs).

And trading away productivity doesn’t seem like a big deal when prosperity is widespread, as it is in the US now. But it might matter a very great deal in future years, when we find our standard of living rapidly being outpaced by those of countries with more-dynamic economies.

Second, keep in mind that today, America’s most important export is money. We still produce goods and services that other people want in exchange for the ones they produce. But to an unprecedented degree, what we trade to other people is nothing but our dollars, which they are entirely willing to sterilize and hold as central-bank reserves.

This is a remarkable state of affairs, worthy of a very long explanatory post (actually, a whole book). But it ultimately means that we dare not impair the long-term credibility of our money, because it’s what we use to get the goods and services that America no longer produces.

This reality all by itself explains why the Treasury and the Federal Reserve are so eager to ensure that financial markets remain stable, even at the expense of market freedom (which includes the freedom to fail).

It also explains why both Bernanke and Paulson have started busily setting our expectations for a low-growth future.

-Francis Cianfrocca

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