Structurally Unsound

Friday, July 25, 2008

LET'S START with the good news in the giant housing bill that has passed the House and appears bound for Senate approval and President Bush's signature. There may be no greater risk to the American financial system than that posed by the bloated balance sheets and thin capital reserves of Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that dominate mortgage finance. The bill would address this through the immediate creation of a regulatory agency empowered to order increases in the GSEs' capital. Through the end of 2009, the regulator would work in consultation with the Federal Reserve Board, perhaps the only institution in Washington that can equal the GSEs in clout and expertise -- and which has long been skeptical of their public risk-private profit business model.

Fannie and Freddie have long needed (and resisted) firmer regulation; such oversight is doubly necessary now, because the bill would also give the Treasury secretary 18 months of far-reaching authority to bail the companies out, either through a capital infusion or loans. The Congressional Budget Office estimates the cost of a potential rescue at $25 billion, but this is a wild guess. If the standby authority works as Treasury Secretary Henry M. Paulson Jr. intends, the markets will regain confidence in Fannie and Freddie, and the government will never spend a dime on a rescue. But if declining housing prices were to cause massive losses at the GSEs, taxpayers could have to pay many, many billions of dollars. Given the risk, the bill should have provided for a government takeover in the event of a bailout. In fact, there are no specific taxpayer protections, reflecting the administration's wish to remain vague about everything except the ultimate guarantee -- so as to avoid market speculation on various bailout scenarios.

On balance, the bill creates hope that the GSEs, under regulatory tutelage, can get their houses in order by the end of next year so that they no longer pose a short-term systemic risk and that wider reforms can take place. But this is a hope, not a guarantee.

In the meantime, other sections of the bill, which Mr. Paulson accepted as the price of the GSE measures, propose a mishmash of policies whose ultimate impact would be far from certain. Even as the new regulator tries to rein in the high-flying GSEs, the bill urges them into the upper reaches of the mortgage market, via a provision permitting them to buy and securitize loans up to $625,000, in contrast to the present limit of $417,000. While trying to assure markets that the GSEs will raise capital, the bill would also siphon hundreds of millions of dollars out of them to support a three-year program to refinance troubled subprime loans through the Federal Housing Administration. The latter program is billed as a rescue for up to 400,000 homeowners. But since it would require lenders to take substantial losses and offers nothing for holders of second liens, it could fall well short of its goal. And while the FHA refinance is designed to keep people in their homes, elsewhere the bill would offer banks an inducement to foreclose -- in the form of $3.9 billion for state and local governments to spend on properties that were foreclosed on.

Lawmakers can go home in August and tell the voters that they did something about housing. Exactly what they will have done, and at what eventual cost, may be harder to explain.

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