In Crisis, Paulson's Stunning Use of Federal Power
Monday, September 8, 2008
Hurricane Hank swept through the nation's capital yesterday with gale-force regulatory winds and a tidal surge of federal cash, upending two of Washington's biggest enterprises and permanently changing the landscape of housing finance in America.
In wresting control of Fannie Mae and Freddie Mac, and in authorizing the Treasury to begin purchases of mortgage-backed securities, Secretary Henry M. Paulson Jr. has taken responsibility for assuring that low-interest loans will continue to flow into the country's hard-hit housing markets. Not since the early days of the Roosevelt administration, at the depth of the Great Depression, has the government taken such a direct role in the workings of the financial system.
Although the details of yesterday's takeover are complex, the rationale is quite simple: to restore some semblance of normalcy to the housing market. Paulson and other policymakers think that until that happens, neither financial markets nor the wider economy will be able to regain their footing.
Fannie and Freddie did not go gently into conservatorship. Although their access to badly needed equity capital had dried up and their borrowing costs had increased, they had hoped that they could muddle through by raising fees and demanding higher interest rates from borrowers. But that plan was cut short when Paulson, backed by Fed Chairman Ben Bernanke and their newly empowered regulator, James Lockhart, concluded that Fannie and Freddie could no longer reconcile their sometimes-conflicting obligations to shareholders and homeowners without posing additional risks to an already shaken financial system.
Fannie and Freddie could have fought the government in court, but that wasn't much of an option for companies whose business model was based on the perception that they were backed by the government. The market would have shut them down long before the first briefs were filed.
Under the deal they could not refuse, Fannie and Freddie directors and top executives will lose their jobs. Shareholders will lose their dividends, voting rights and most of their ownership stake, while agreeing to pay dearly for the government's money and backing. Left unharmed will be holders of trillions of dollars in Fannie and Freddie debt -- or securities backed by mortgages that Fannie and Freddie have insured against default -- who will get all their money back, with interest.
In figuring out where all this goes, it is useful to understand how we got to this point.
Until this weekend, Fannie and Freddie have been unique entities -- for-profit, shareholder-owned companies that were required by government charters to provide low-cost capital to secondary mortgage markets in good times and bad. And for most of the past 40 years, the companies have managed to balance those missions fairly successfully. Shareholders have earned a better-than-average return on their investment, while homeowners have had access to mortgages that not only have lower rates than in other countries, but rates that they can lock in for up to 30 years.
But in the mid-1990s, things began to change. Rather than being satisfied with modest growth, Fannie and then Freddie began promising Wall Street double-digit earnings growth, which required them to grow their balance sheets well beyond what was necessary to assure liquidity in the mortgage market. Instead of just buying mortgages, insuring them and selling them in packages to investors, they bought more of them for their own portfolios, using ever-increasing amounts of borrowed money. Buying their own securities was profitable, but it left them highly exposed if anything went really wrong with the housing market, which is exactly what has happened.
By 2005, however, Fannie and Freddie found they were losing market share to private competitors offering new, highly profitable mortgage products that they had generally ignored -- variable-rate mortgages to homeowners with poor credit histories who offered little or no documentation and borrowed more than 80 percent of the estimated value of their property. To varying degrees, Fannie and Freddie decided to jump into these markets, both by insuring and packaging these mortgages and keeping some of them on their own books. That decision, too, has now come back to haunt them.
It is fair to blame Fannie and Freddie executives for these misjudgments, although they were no more misguided than others in the industry. Some of the blame also goes to Fannie and Freddie's regulators -- both Lockhart and his predecessor -- who failed to use their limited powers to rein in the companies' growth. And a good chunk of the responsibility should be assigned to elected politicians -- the Clinton and Bush administrations, which encouraged the jump into the subprime market by imposing more ambitious "affordable housing" goals on the companies, and Congress, which spent much of the past eight years locked in a bitter ideological battle over Fannie and Freddie rather than giving their regulator the stronger powers and mandate that it needed.
It will now take several years at least for Fannie and Freddie to dig out of their financial holes, even with the infusion of taxpayer money. But that will not resolve the long-standing question of whether a for-profit company with some sort of government backing is the best way to assure a steady flow of low-cost capital to the housing markets.
The crisis reminds us that, left on its own, the private sector will over-invest when the housing market is hot and then abandon the market when boom turns to bust. That's why Fannie and Freddie were invented, and why keeping them afloat now is crucial.
But the lesson from the recent debacle is that if we are going to rely on government to bail out private entities, then government ought to have a much stronger hand in making sure a rescue is never needed.