Rescued by Fannie Mae?

By Susan E. Woodward
Tuesday, October 14, 2008

The most important task of the Federal Reserve and the Treasury right now is to restore confidence in bank solvency -- hence the Treasury's move to spend the first $250 billion of the Troubled Asset Relief Program (TARP) buying ownership stakes in a range of banks. Nonfunctioning markets and dried-up liquidity are symptoms of universal suspicion of insolvency, and lending among banks will resume in earnest only when banks are known to be solvent.

The original plan under TARP was for the Treasury to buy up suspect mortgage-related assets. Mortgages, by themselves or bundled into mortgage-backed securities, lack a functioning market. Any prices set in the near term are likely to be grossly below the true economic value (reached from holding until borrowers complete their payments or cash from foreclosures arrives). By buying stock in banks, the Treasury injects cash, allowing institutions to hang on to assets worth more than the market will pay for them now. In the immediate term, this both helps the banks and calms the markets. But it does not directly solve the underlying problem with the troubled mortgage securities.

The true values of mortgage assets are generally thought to be a mystery. But little-mentioned among discussions of the subprime troubles and other aspects of the crisis is that the Treasury has access to the best resources in the business for estimating the hold-to-maturity values of mortgages and mortgage-backed securities. This team is at Fannie Mae, which the government now effectively directs.

Fannie has an underwriting and valuation shop with models for valuing mortgages that are up and running. Key inputs to these models are Fannie's own indexes of property values at the Zip code level -- others make do with prices in entire urban areas. The data needed are not difficult to assemble: current loan balances, the date loans were originated, original property value (or appraisal for refinances), loan type (fixed, adjustable rate, ARM features, loan length), borrower's credit score, Zip code and current loan status. These models project payments and proceeds from foreclosures and calculate the property's present value. Similar but less detailed models in recent academic work show that they do quite a good job of projecting defaults for prime and subprime loans, given changes in property values.

Some argue that Fannie is discredited for this work because it, too, has losses on riskier mortgages. But Fannie's losses arose from a failure to reserve adequately for losses that were anticipated by its models. Fannie's business people overrode the risk managers when making the decision to keep reserves too low. The models were right.

In 1933, and even in 1989 during the savings-and-loan crisis, a quick revaluing of the majority of the nation's mortgage loans was not possible. Today, though, it is. In a few weeks, the right team could produce tens of millions of valuations, making a constructive plan of action quickly practical.

Right now, many institutions are solvent but not obviously so. Prevailing confusion about the value of their mortgage holdings hobbles them in credit markets, which means nobody wants to lend to them and they quickly become insolvent. With valuations based on the best available current data, confidence would be restored in banks with truly adequate capital, and their role in the credit market resumed. If more equity or government insurance is needed to secure confidence, this can be provided on terms reflecting informed mortgage values. This step by itself could save taxpayers hundreds of billions of dollars unnecessarily pumped into institutions capable of dealing with mortgage losses on their own. It has not been the usual function of bank regulators to publish values of bank portfolios, but these are unusual times.

There is no point in the Treasury buying stock in insolvent banks only to have it gobbled up by losses. The Treasury will be more successful in containing the cost of using its new powers if it begins with the best available estimates of mortgages' hold-to-maturity values. Where solvency is confirmed, liquidity will follow. The original plan of simply buying assets would not have resolved the crisis. But it had a nugget of truth -- the importance of knowing the true values of the questionable assets. Now that the plan has morphed to injecting banks with capital, those asset values are still paramount for the best use of Treasury's resources. No other institution has as much data, so well organized and ready to address the specific problem the Treasury confronts, as Fannie Mae. Turning to Fannie for help is Treasury's fastest and least costly option to help our financial markets resume normal operation.

The writer served as chief economist at the Department of Housing and Urban Development from 1987 to 1992 and as chief economist of the Securities and Exchange Commission from 1992 to 1995.

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