Monday, July 14, 2008

Cleaning Up Fannie and Freddie

I noticed that gold went up $10 this morning to around $970 on the news that Uncle Sam will backstop mortgage lenders Fannie and Freddie. Gold, of course, is still a key barometer of dollar value and future inflation, while it may be a sidebar to the bigger story of saving Fannie and Freddie.

Inside the government bailout is yet more power for the Federal Reserve, which will be given “a consultative role” to set capital requirements and other “prudential standards” for Fannie Mae and Freddie Mac. This comes on top of the Fed’s power-grab to regulate Wall Street investment banks and become the “financial stabilizer” of last resort.

The sinking dollar and rising gold price in recent years suggest market doubt about the ability of the Fed to maintain price stability and a stable dollar in the face of all their other responsibilities to inject liquidity into the banking system as a safety backstop measure — or for that matter to keep the unemployment rate low. The New York Sun’s Seth Lipsky has been making this point and it’s a very good one.

As for the rescue of Fannie and Freddie announced last night by Treasury man Paulson, it’s a necessary and prudent move in order to avoid a global financial blowup. Everybody owns Fannie and Freddie bonds here in the U.S. and around the world. So, in effect, Fan and Fred paper is now explicitly guaranteed with the full faith and credit of the U.S. government.

However, one key point is what to do with the portfolio holdings of Fan and Fred. You see, these banks have two purposes: One, they purchase mortgage loans made by local lenders and then repackage them into bond-market pools that are sold to investors with the U.S. government’s stamp of approval. But their other business activity is to purchase mortgage loans for their own portfolios, essentially setting up a high-risk internal hedge fund. This is what caused stock market investors to slash Fannie and Freddie share prices nearly 50 percent last week, leading to much angst.

According to expert Peter Wallison of the AEI, Fannie Mae has a $780 billion portfolio of mortgages and derivatives. Freddie Mac’s is about $680 billion. Some believe under fair-value accounting that these portfolio holdings are deep in the red. My question is whether under the new rules U.S. taxpayers are gonna be on the hook for these portfolios. Wallison tells me that the new regulatory approach coming out of Congress permits the new Federal Housing Finance Agency supervisor to gain control of these risky portfolios and to gradually downsize them and ultimately sell them off. If this reform takes place it will be a good thing. If the reform is not implemented it will be a very bad thing and will keep Fannie and Freddie doing exactly the same high-risk things they have always done.

Incidentally, it would be good if the new regulatory regime insists upon board members for Fannie and Freddie who have true mortgage and financial expertise, rather than the political roster that has governed these agencies for decades. The two guys running Fan and Fred, Dan Mudd and Dick Syron, are financial guys. But in the past, at least for Fannie, CEOs have too often been political people — like Frank Raines, the former Clinton budget director, or James Johnson, former Mondale aide-de-camp. Both Republican and Democratic appointees have been placed inside Fannie, even though they have no expertise. It’s a great place to make a lot of money, but at taxpayer expense. For example, Jamie Gorelick, former general counsel to the Clinton Defense Department and later deputy attorney general, had a big Fannie Mae job. But it’s hard to see how she was qualified to take a senior mortgage-lending position.

All this sort of thing has to be cleaned up.