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Interpreting the Nationalization of Fannie Mae and Freddie Mac

What Fundamentally Changed Yesterday?

There are two points I want to make to you this morning, as the impact of yesterday’s nationalization of the mortgage GSEs works its way through the system. Here’s more information.

First: while this is most definitely a fundamental change in the structure of the mortgage markets, it is not a change in our government’s existing policy of deep intervention in housing. The people who are expressing disgust at the largest nationalization in the history of the world are missing a few key points.

Second: early indications from overseas markets show that the move will be received very favorably. In fact, it could change the landscape in the financial markets. It’s far too early to say this out loud, so I’ll just whisper it very softly: there’s a possibility that we’re at the beginning of the end of the long credit crisis.

Keep reading, there’s more.

Market reactions: expect to see a sharp drop in the prices of US Treasury securities, while agency securities and other classes of debt either rise in price or stay the same. That means a reduction in credit spreads.

As I write in New York on Monday morning, the stock market looks set to rise at least 2%. US Treasury securities are sharply lower, but not nearly as low as they traded last night in Tokyo. Asian markets overnight were extremely volatile and choppy.

What’s the impact on mortgage rates? Unless something changes this picture, I would expect to see a nearly-immediate reduction in retail mortgage interest rates. We’ll know by the end of this week or maybe next week.

And I shouldn’t have to point out the obvious ramifications of this for the Presidential election.

But the nationalization of the GSEs doesn’t constitute a fundamental change in the structure of the housing market. That’s because, during the New Deal when Fannie was founded, the government decided to support the housing market as a matter of policy. (That’s also why mortgage interest payments are deductible from income taxes, which is a kind of socialism I don’t hear any of us saying should end.)

The US housing market has already been nationalized for decades. The fig-leaf of private ownership that the government wrapped Fannie Mae and Freddie Mac with has actually created more problems than it has solved. And Paulson and Lockhart made this exact point forcefully in their statements yesterday.

It will be for the next Administration and Congress to debate what will be the precise role of the Federal government in US housing markets going forward. Game on, it will be a debate that we’ll have a lot to say about here at RedState.

And for a striking clue as to the direction that debate should go: the nationalization plans announced yesterday specifically direct Fannie and Freddie to start shrinking their asset portfolios over time.

The terms of the conservatorship impose a final limit of $850 billion on the asset portfolios that each GSE may have. That’s pretty close to where they are right now, and the small increase is congruent with this year’s statutory mandates that Fannie and Freddie support the mortgage market through the current crisis by expanding loan origination.

However, beginning in 2010, the GSEs are expected to allow a target of 10% of their total portfolios to run off each year. The goal is for them to reach no more than $250 billion each, over some open-ended period of time, probably in the neighborhood of 5-7 years.

That’s an extremely important point. The takeover of Fannie and Freddie is being done in the context of a goal to make them much smaller than they are now, which means either that most of these assets will ultimately be privatized, or that a brand new Federal entity will be created, or a combination of both.

We now have a rate of homeownership in the high 60s, but during the Depression (and especially in 1938, which was a recession year) it was much, much lower. And in those days, you generally couldn’t get a mortgage unless you could put down half the value of the house or more.

Roosevelt’s people were smart enough to understand something that we’ve lost sight of: if you give people an ownership stake in society, they won’t turn Red on you. In the late Thirties, a Bolshevik revolution in America was considered a real possibility. The radicalism of the Sixties moved from everyday life to its permanent home on college campuses as soon as the hippies got jobs and started making mortgage payments.

So Fannie Mae was founded in a year (1938) when American Communism was very strong, and Freddie Mac was founded in a year (1970) that was exceedingly concerned about student radicalism. See the parallels?

So what Hank Paulson did yesterday is nothing more than change the label on what has long been de facto Federal control over housing. He and Lockhart explicitly said, multiple times, that they’re not engaging the policy debate on federal support of housing. They’re just keeping the global financial system from melting down, long enough for Congress to engage the debate next year.

The reason the GSEs got so big is, ironically enough, because of the one thing Bill Clinton is supposed to have gotten right: fiscal discipline. It turns out that the world is hungry for risk-free debt. For one thing, it’s the foundational asset for modern portfolio management.

So as soon as Bill Clinton raised taxes, and our budget deficits got smaller, the Treasury started issuing less debt to fund the smaller deficits. What happened next?

What happened was that Franklin Raines, then-CEO of Fannie Mae, started a massive marketing push to sell agency debt to global investors as a substitute for Treasury debt, on the strength of the implicit government guarantee. Today, direct agency obligations and agency-guaranteed mortgage-backed securities are probably the biggest asset class in the world, apart from US Treasury obligations.

The investors who bought this paper weren’t looking for exposure to US mortgages (as Wall Streeters, including me, later came to fantasize). They were only looking for benchmark credit.

And this year, they decided that US mortgages were too risky to play that role after all. So they quietly came to Paulson earlier this summer and said to him: “Listen. You’re going to leave office soon. And we’re not going to let you get away before you fix this mess.”

There’s no way to put enough lipstick on this pig: Fannie and Freddie have issued $1.6 trillion in assets on top of $70 billion in shareholder equity. That’s a rate of capital efficiency that’s simply untouchable in the private world, and that’s why mortgage interest rates have been so low (and home ownership rates so high) for so many years in the US.

If you were to fully open the mortgage market to private competition today, (which you simply can’t because Fannie and Freddie already own or guarantee half of it, and it would take ten years for that to run off), retail mortgage rates would probably nearly DOUBLE, and housing values would plunge.

And what would happen then? That’s right: Republicans and Democrats alike would be howling for a New New Deal.

-Francis Cianfrocca

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