By Sebastian Mallaby
Monday, July 14, 2008
Capitalism has triumphed everywhere, but it's time to dust off an old socialist slogan. When it comes to housing finance, the commanding heights of the economy must be nationalized. Last night's statement from Treasury Secretary Hank Paulson was designed to look statesmanlike and measured, but it misses an opportunity.
You can understand why nationalization is not Paulson's first choice. Fannie Mae and Freddie Mac, the two monster housing-finance companies, between them owe trillions to their bondholders. Nationalizing that exposure would appear to inflate the federal debt, and there's been talk of damage to the nation's credit rating. Moreover, Fannie and Freddie have made or guaranteed almost half of all loans to American homeowners. Can it be healthy to have the government control that much lending?
Of course not. But nationalization is healthier than the other options.
Start with the fact that, despite loud official denials until last night, the government will have to inject money into the mortgage lenders. Intervention may be precipitated as early as today if Freddie has trouble with its plan to borrow $3 billion in the markets. Even if the lenders escape the bond market equivalent of a bank run, which is what destroyed Bear Stearns, they are likely to succumb to a variant that might be called an "equity run."
Investors know that Fannie and Freddie need to raise fresh capital, diluting existing shareholders. So they have been marking the shares down, which means that, to raise any given sum, Freddie and Fannie must sell an even greater percentage of themselves to new investors. The prospect of a larger dilution drives the stock down further, setting off a vicious cycle: Last week the firms' shares lost nearly half their value. The upshot: Fannie and Freddie can't raise the equity that everyone knows they need.
If public money is going to be injected, the question is how to provide it. For politicians squeamish about nationalization, the easiest course is to have the Fed lend to Fannie and Freddie. The Fed confirmed last night that it stood ready to act, and after all that has happened over the past year, the public would probably accept emergency Fed loans as part of the new normal. But in addition to bailing out private investors and undermining market discipline, a Fed rescue would put taxpayers on the hook with little to no compensatory upside.
If the government is going to risk taxpayers' cash, it should inflict punishment on private players and demand an equity-type payoff. So the issue is whether to become a minority shareholder or, at the other extreme, the sole one.
Paulson made clear last night that he favors a minority stake. But from a purely financial perspective, it would be better to buy the whole caboodle. If the government is going to supply a rescue, why share the upside? The worry about adding to the federal debt turns out to be a digression. Although Fannie and Freddie owe an astronomical amount, they are owed a roughly similar amount. The net effect of nationalization on the federal debt would be modest.
Of course, we wouldn't want the feds buying General Motors even if its assets represented a bargain, because we don't want the government in the car business. But Fannie and Freddie are special. Their murky public/private status is odious.
Fannie and Freddie are private, profit-seeking businesses that enjoy unfair advantages: They get regulatory and tax breaks, and they borrow more cheaply than other firms because the government stands behind them. When they grow and do well, they pay their executives lavishly, so the executives are always pushing to expand. But the bigger the lenders get, the larger the threat to taxpayers. And, because their collapse would be catastrophic for the financial system, the larger the threat to the economy.
What do taxpayers get out of this arrangement? Fannie and Freddie used to say they were vital in making mortgages available to low-income households. But the subprime debacle shows that low-income households had too much access to credit, not too little. Fannie and Freddie now say they are vital to keeping the mortgage market operating in hard times. Over the past year this has proven true, but there is a limit to how far Fannie and Freddie can play this role: witness the collapse of their share prices.
As long as Fannie and Freddie retain their private/public form, private managers will invent reasons to grow courtesy of public assistance. The best shot at taming them is to bring them into the government. Then, once financial markets have stabilized, the government should shrink the institutions radically and spin them off in pieces, creating maximum space in the mortgage market for smaller private players.
The collapse of Fannie and Freddie's share prices presents an opportunity to buy them on the cheap. Rather than rushing to prop up these behemoths, authorities should seize the moment: Nationalize -- and then dismantle.