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Pearlstein: Fannie and Freddie

Steven Pearlstein
Washington Post Columnist
Friday, July 11, 2008 11:00 AM

Washington Post columnist Steven Pearlstein was online Friday, July 11 at 11:00 a.m. ET to discuss the financial crisis and government-backed mortgage giants Fannie Mae and Freddie Mac.

Read today's column.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

Pearlstein was honored with the Pulitzer Prize for commentary for his columns about mounting problems in the financial markets. His award was one of six Pulitzer Prizes won by The Washington Post this year.

A transcript follows.

Read Pearlstein's latest columns.

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Falls Church, Va.: Hi Steve-

I'm a former Fannie employee with a jaundiced view of the current reactionary goings-on in the financial markets.

In your opinion, how much of this current brouhaha has to do with the recent FASB rulemaking and its applicability to the GSEs, versus any real systemic weaknesses?

Thanks!

Steven Pearlstein: Obviously there is a fair amount of market overreaction going on. There is no new information here to cause the price of these stocks to crater like this in such a short time. It is obviously fear, which has reached a tipping point among some longtime Fan and Fred investors, who have watched the stock slide for months now and may have decided they don't have the stomach for it any more. There also may be a lot of short selling pressure. In any case, once these runs get going, there is a lot of piling on that goes on, with even more analysts coming out warning of this or that. If I were you, I'd keep an eye on the spread between what Fannie and Freddie have to pay to borrow, and what the Treasury does for an equivalent bond or note. Its high by historical standards -- 75 basis points or so, when I last looked -- but not outrageous, and it hasn't gone up that much in recent days. That's the thing to watch.

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Pelham, N.Y.: Why does the business press not explain that the destruction of trust in our financial institutions was the consequence of thousands of discrete decisions made by specific individuals? You act as though some amorphous process, like lava flow, is at work here, when we need to name names.

Fannie Mae did not mysteriously decide to start bundling mortgages of low quality. Someone in that agency made conscious decisions to lower the bar. It is the duty of the business press to identify the mischief makers who have poisoned our economy through their personal corruption.

These crooked people are in the ratings agencies, the regulatory agencies, the quasi-government institutions, and of course, the Wall Street firms. The business press will make itself ridiculous if it pretends that it cannot grasp the cause of this massive failure in our capital markets. The cause is plain; but organizations like WaPo lack the courage to address it, because they too have grown corrupt.

Corruption is the word that you dare not speak, but it is everywhere apparent.

Steven Pearlstein: Sorry, but we really don't deserve the blame on this one. Nor do Fannie and Freddie, as the primary culprits. As they were set up to do by Congress, Fannie and Freddie insure mortgages WRITTEN BY OTHERS against default. They charge a fee for this insurance, which up to now has been the source of a fair amount of its profits. It sets standards for mortgages it insures, which in general were pretty good but, in hindsight, were probably not tight enough. So it wound up insuring some of the mortgages that are now going bad, but definitely NOT the worst ones. Those were uninsured, or insured by private bond insurers who are in even more trouble than Fan and Fred.

The bad actors have been identified, by type and name, many times in this and other newspapers: the brokers, the mortgage bankers, the Wall Street securitizers and underwriters, the rating agencies, appraisers and regulators (if I left anyone out, I apologize). Some of us in the press have been warning about this for a long time and naming names, as you suggest.

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Rockville, Md.: Steve,

Congratulations on your Pulitzer. What is the ability of Fannie/Freddie to raise capital independently of the government? Or, is a government subsidized investment the only option? If they collapsed, e.g., became insolvent, what would be the impact? I imagine rates would go up a bit, but aren't there other firms to step into the gap? Thank you.

Steven Pearlstein: Thanks. The prize seems like a long time ago, already.

Look, these things are a bit complicated and the vocabulary is important to understand. Fannie and Freddie raise trillions of dollars of capital by issuing their own bonds, or IOUs, and they are widely held among banks, mutual funds and even central banks around the world. Most investors treat them as if they are as safe as Treasury bonds, because the assumption is that the government would step in and backstop them if Fannie and Freddie got into trouble. That's what people mean when they talk about an "implicit guarantee." And as we heard this week from Secretary Paulson and others, that implied guaratee seems as valid as ever.

Nor is Fannie or Freddie running out of cash with which to pay its expenses and its debt, or running out of the ability to refinance its debt when it comes due. So no problem there.

What is happening is that Fannie and Freddie are required, by accounting rule, to record paper losses because the immediate trading value of the assets on their books -- and in this case assets means mortgage loans that it holds--are going down. It probably has no intention of selling those now, so that is a somewhat theoretical problem. But that's what the accounting rules require, and as a result, it must record a "loss" for those on its quarterly income statement. That loss is then deducted from the value of shareholder equity on its balance sheet, thereby reducing the "capital" it has to serve as a cushion against further losses. That's basically what all the fuss is about.

Now I should add that the companies are also having to take additional "reserves" against the possibility that they will have to make good on more of those insurance promises I mentioned above because of rising default rates, even among the higher quality mortgages that Fan and Fred insured. And those additional reserves (which aren't money out the door yet, but could eventually turn into that) also detract from profits and from capital.

Sorry for all the accounting jargon, but it is important to understand what is happening here and what is not.

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Anonymous: I am a 79-year-old retiree who depends upon Social Security and IRA distributions for my retirement income. A major part of my IRA assets is in Fannie Mae and Freddie Mac bonds. How concerned should I be about the possibility of a default on those securities?

Steven Pearlstein: Not much at all.

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Algarrobo, Chile: Mr. Pearlstein,

The fact that Fannie and Freddie are on the brink, specifically speaks of a crisis of confidence in a financial system that has been running on empty for some time now, more to the point, the US currency is becoming meaningless. Inflation attests to this. Are we supposed to continue believing in a fiat system where problems continually are papered over? Your thoughts on this intrinsic situation please?

Steven Pearlstein: Fannie and Freddie aren't really on the brink and while the dollar has been the source of weakness, it is hardly a worthless piece of paper. I think you are overstating things -- and that comes from a guy who's been warning about stagflation and the credit bubble for a long time.

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Washington, D.C.: Perhaps the time is right to consider privatizing/nationalizing Fannie and Freddie. The current structure of having private shareholders and quasi-government status just doesn't work, but the enterprises had become too big to do much about it. They have consistently been successful in lobbying for watered-down oversight, are doing it again, and their shareholders and management have received millions that could have gone to better use, not to mention what they've paid out to lobbyists over the years. I really hope congress and the administration will look for a larger-scale solution that will address these problems and not simply a capital injection that gets them back on their feet and preserves the status quo.

Steven Pearlstein: I may be the last person in Washington who actually likes the hybrid structure of Fannie and Freddie, which have to balance their public mission (providing liquidity to the housing finance market, particularly for low income housing) and their duty as a public company to maximize LONGTERM returns to their shareholders. They are unique entities, and investors need to understand that they are not like other companies because of that dual mandate, which is sometimes a conflicting mandate. And right now we are in one of those periods.

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Danvers, Mass.: I used to talk with these guys all the time. The game was "to maximize the value of the subsidy (implicit guarantee, etc.)" and then to capture as much of this as possible for management in stock, options, whatever.

But be that as it was...

They perform a critical market function in the guarantee operations. Having the US balance sheet stand behind the guarantees shouldn't be too expensive, and it is the original policy objective anyway. If the companies go BK and the US in receivership explicitly guarantees the guarantees, then I fail to see where the problem is. What am I missing?

Steven Pearlstein: Not much.

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Vienna, Va.: What do you think would happen to Freddie Mac share prices if the federal government instigated a "bailout" of Freddie Mac and Fannie Mae?

Steven Pearlstein: If, in a bad scase scenario, the government has to pump some equity capital into Fan and Fred to stem this panic, then it will probably take some preferred stock in the company which will pay a dividend higher than its borrowing costs. And after this crisis passes in a few years, it will be able to sell the stock back to the company at a price higher than it paid for it. So the long answer to your question is that it shouldn't cost taxpayers anything.

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Dunn Loring, Va.: Steven: Last summer I asked you what were the chances of a recession in one of these chats and you answered "66 percent." Yesterday I learned that what's happening is just a "mental recession." That aside, what are the chances of a real depression as, to tell the truth, this reader is feeling a bit depressed right now (though it's probably psychological)?

Steven Pearlstein: Not sure what the definition of a depression is, but with some flexible, sound policy making, there's no reason we need to get into anything like the 1930s. We'll have a recession that could last a year, followed by several years of slow growth, all of it with an overlay of inflation. I've been saying that for some time now. So things aren't going to feel really great for some time.

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Los Angeles, Calif.: Hi Steve, love your smart column. Three questions:

1. Why does the current crisis feel like the same overreach by accountants that doomed the S&L industry in the 89-91 time frame and yet those who bought the S&L's at the bottom (Ron Perelman, Bass, etc.) made billions? Same vicious cycle.

2. To what extent is the demise of the "short tick rule" and obvious naked shorting of stocks on a daily basis contributing to the crisis? Shorts are emboldened by these rule changes.

3. To what extent is Schwarzmann of Blackstone right that the accountants have caused this crisis??

Steven Pearlstein: All good questions. One lesson from the S&L crisis is that if you just have patience, and don't push banks or other insitutions into dumping loans but instead hold on to them, the ultimate losses may be much less than the market is now pricing. That's why those bottom fishers made so much money -- because the underlying assets were actually in better shape than the market price suggested.

One name for patience for regulators is forbearance. And that's why I wrote this morning that a little well-polaced forbearance in the right places can save us all a lot of problems and avoid unnecessary losses and failures. I also wrote about a bit of flexibility in terms of how to account for assets that are now on the books of banks and other institutions, which is what Mr. Schwartzman was calling for. If you require everything to be marked to the current "market" price, even though the markets have virtually collapsed because there are no buyers, then you are turbo-charging this self-fulfilling dynamic and creating a vicious downward spiral. I probably wouldn't give institutions as much flexibility as Mr. Schwartzman would in pricing these things, and I think institutions have an obligation to tell shareholders and creditors the ugly truth about what they are holding and what the market values are currently. But that doesn't mean that those values have to be used in the official quarterly accounting.

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Troy, N.Y.: Hi Steven. You had an impressive appearance on Kudlow & Co. a week ago. You should be on more often. Anyway, with Fannie & Freddie racing towards zero (I hope they don't get there), what do you think is the least bad option for finance/housing? I am beginning to agree that a little bit more regulation cannot be much worse than our current situation. Should we have another agency for banking/housing regulation, with the Federal Reserve focusing on 'price stability' and 'full employment'?

Steven Pearlstein: We have the institutions we need. We just need to support them in whatever ways are necessary to keep them functioning.

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Thoiry, France: In NYT I recently read the following:

"Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee - which could be staggering - would be paid by taxpayers.

The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt."

My questions are: If the companies are under a conservatorship is not its $5 trillion of debt de facto guaranteed by the government ? If not, what is the point of it ? And has the US public debt then doubled? What does that do to the dollar?

Steven Pearlstein: Look, don't read too much into those statements. To say the public debt would magically double is technically true, but is mostly meaningless. That Fran and Fred debt has been out there for years with everyone assuming it is the same as Treasury debt, if push comes to shove. And all of that is reflected in the prices of assets and the value of the dollar. Furthermore, the reason that debt is still well regarded is that there are assets behind it -- all those mortgages on Fannie and Freddie's books, and while the default rate is going up, it's still pretty low. So let's not use vocabulary when we are talking about Fan and Fred that suggests there is nothing there. There's plenty of value there -- in my opinion, enough value to pay off all of its debts over time and provide equity for shareholders as well. And its not must my opinion -- it is also the opinion of Fan and Fred's regulator, who is not known to be a softie on these organizations.

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Rockville, Md.: Is Phil Gramm proof that one should never tell an unpopular truth in an election year? Whiners? Ho boy!

Steven Pearlstein: No, because he didn't speak the truth. We are in a real recession, as the data will soon confirm.

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Durham, N.C.: What will happen to Fannie Mae's Preferred debt such as FNM-S in the event of a bailout? This non-cumulative security has dropped from a high of 32 to 18 plus change. Could Fannie Mae default on its many securities?

Thanks,

Hugh

Steven Pearlstein: If its debt I assume it will benefit from the implicit Treasury guarantee.

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Vienna, Va.: Mr. Pearlstein - I'm not an economist. But I of course have been reading up daily as far as the goings-on with the current economic downturn. Would it be prudent to say that this turmoil continues into 2009 and that we are at least two years off from any meaningful recovery?

Steven Pearlstein: That sounds right.

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St. Louis Park, Minn.: Thanks for today's sobering column.

At what point does the spread or "cost" that Fannie Mae & Freddie Mac become too high for those institutions to effectively work?

Thanks, Roger

Steven Pearlstein: In theory, their business model could work at higher spreads, although that will mean higher mortgage rates for homeowners. Since the private sector is not interested in doing this business now, Fannie and Freddie would continue to pick up the slack. But when things normalize, if Fan and Fred don't have a funding advantage, then they would have a much more limited role in the housing finance system.

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McLean, Va.: About six weeks ago, you gave a an assessment of "slim" when asked the chances that Fannie or Freddie get nationalized. Care to revisit?

Steven Pearlstein: That's a semantic question really. If the government injects $20 billion and takes preferred stock but still doesn't own more than half the equity, is that "nationalization?" Beyond semantics, you are right, I didn't envision this run on its stock price.

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Washington, D.C.: Isn't there an argument that if bad banks go down in an "orderly way" as Paulson would say, that we might be better off?

Steven Pearlstein: Yes, some banks and investment houses should be put through an orderly liquidation. That's exactly what Bear Stearns is going through. Some of its assets were sold for peanuts, and the least desirable ones are being held and managed by the Fed, which bought them at a deep discount and, with any luck, will actually make money on them when they are finally sold.

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Pelham, N.Y.:"Obviously there is a fair amount of market overreaction going on."

If you do the arithmetic of a relatively small percentage of mortgage defaults wiping out all of Fannie and Freddie's capital, is that "overreaction?"

Steven Pearlstein: First, you are assuming that they don't or can't raise more capital. Second, you have to distinguish cash flow from book value where you have some assets marked at prices that may be below what they will prove to be worth. In the sense most people mean it, these institutions are not insolvent.

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Washington, D.C.: What would happen if the government honored the language used when creating Fannie Mae and Freddie Mac that explicitly says they are non-governmental organizations and do not have the financial backing of the federal government and one or both failed, forcing them into a normal bankruptcy proceeding?

Steven Pearlstein: You'd have a global credit market crash.

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Washington, D.C.: I'm a little confused about what is happening with Fannie and Freddie. My understanding is that by and large, loans underwritten to be purchased by Fannie and Freddie were not subprime loans. While many subprime loans are delinquent, is that true of the standard Fannie/Freddie loans? If not, is this "crisis" a misunderstanding of Fannie and Freddie risks versus the risks of the Wall Street lenders in the subprime market? After all, if there is only a small majority of Fannie/Freddie loans in delinquency, how can that bring down such huge companies?

Steven Pearlstein: They can't, unless people start losing faith and dumping its stocks and bonds. Remember, finance is a confidence game and if people start to lose confidence all at once, even if it is irrational, you can cause a lot of damage.

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Reston, Va.: The executives at Freddie Mac and Fannie Mae should not have access to taxpayer funds.

Personally I see the problem as one where pricing based on supply and demand has been all but eliminated. Remember the old "assumable loans". Consumers are no longer offered that option.

These days prices appear to be "managed" by market segment. Real Estate is a great example of how an industry was used to generate wealth.. it really gets incredible when you look at how banks had created an ever-spiraling upwards asset generator.

Steven Pearlstein: Fannie and Freddie executives do not have access to taxpayer funds, in the way you clearly mean that. And this is exactly the sort of thing that I was referring to when I said we have to stop thinking about this as if it is a morality play.

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Pelham, N.Y.:"It sets standards for mortgages it insures, which in general were pretty good but, in hindsight, were probably not tight enough."

Are you asserting that Fannie and Freddie did not relax their standards for mortgages they were willing to securitize during the Bush Administration?

Steven Pearlstein: First, this has nothing to do with the Bush administration. Second, I don't know if they relaxed their standards, exactly, but when confronted with new mortgage "products", they decided to package and insure some of them that they probably wish they hadn't. These include first mortgages that had piggyback seconds, I believe, and some adjustable rate mortgages lent out at teaser prices. One reason they did this was so they could meet their affordable housing goals.

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Oviedo, Fla.: Hi - hmmm, I seem to recall you suggested taking a cash position when the market was 13,500 or higher, last year. I opted to stand pat, didn't sell stock mutual funds and here we are, screeching toward 10,000 like a runaway luge on a greased track. What does your crystal ball say for the rest of 2009? I didn't go more heavily into cash as I am too young for that posture - 49. Was I a sucker? Now what?

Steven Pearlstein: Well, thanks for noticing. The market may get as low as 10,000, although I wouldn't predict that. But at this point, you may be best to hold on to the companies you think are good and dump the ones you think are going to take the worst of this storm and may not look so good to you in the long run.

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Gainesville, Fla.: Re: Your answer to Question by Pelham.

You said: "It sets standards for mortgages it insures, which in general were pretty good but, in hindsight, were probably not tight enough."

I think some of us wonder if they lowered those standards, made them looser, not merely in bad judgment mode, but in greed. Is that out of the question? Why else would they want to increase their risk?

Steven Pearlstein: You know, I'm a business reporter and columnist, so I have problem with questions about greed. Companies and individuals in a capitalist system are supposed to be greedy, if by greedy you mean maximizing their economic welfare within the bounds of the law. I ASSUME greed, and move on from there. Think about it: are people greedy when they shop at Wal-Mart rather than Macy's to save 20 percent on an item? Yes. And that's a good thing.

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Washington, D.C.: Does either candidate have a concrete, realistic plan to deal with this issue, or are both equally amorphous?

Steven Pearlstein: You know, this isn't something that is best discussed on the stump, other than in the broadest strokes.

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Just a thanks for the column and chat...: My brother-in-law works for Fannie Mae, and the biggest issue they have is that a lot of people just don't understand what they do. Just reading this chat, I have a far better idea, so thanks for that!

Steven Pearlstein: You're welcome. Call your brother in law and tell him you love him. He's probably feeling a bit down right now.

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Chicago, Ill.: The Chinese central bank and many other foreign central banks are supposed to own billions of dollars of Fannie and Freddie debt. Will the "implicit" federal government guarantee be good enough for them? Also, how will American taxpayers feel about making good on that guarantee and paying off the foreigners?

Steven Pearlstein: I sincerely doubt it would cost taxpayers much to make good on that guarantee.

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New York, N.Y.: Steve, After we've moved on from this recession, however long it takes, do you have any reason to think that things will be any different on Wall Street? Are the extreme excesses and greediness going to return like this credit crunch has never happened? I'm very skeptical that Wall Street has any long term memory.

Steven Pearlstein: I'm skeptical too. They just can't help themselves.

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Washington, D.C.: You wrote:

"Nor does Fannie and Freddie, as the primary culprits. As they were set up to do by Congress, Fannie and Freddie insure mortgages WRITTEN BY OTHERS against default. They charge a fee for this insurance, which up to now has been the source of a fair amount of its profits."

I disagree that Fannie and Freddie are not the primary culprits. Yes, they were established by congress to insure mortgages, but they successfully lobbied to have to hold very little capital against that insurance (look at their capital requirements compared to that of banks and thrifts for the very same mortgage) and were able to charge fees that for years were way above the losses they experienced because they had no competition. And they made huge amounts by holding mortgages and securities in their own portfolio because they could issue debt at very low rates because of their quasi-government status and thus make larger spreads than banks and thrifts on those mortgages and securities. So they had huge profits which were paid out to managers, shareholders and lobbyists. And anytime someone in Congress suggested they be reigned in, they replied "it's a tax on housing" and successfully shut it down.

It might be interesting to compare where they opened satellite offices and made local investments with who served on the banking committees.

Fannie and Freddie are responsible for the mess they're in now along with our elected representatives who have been all too willing to be bought off by some donations and investments in their districts.

Steven Pearlstein: Well, some of the things you say are true -- they were piggy in building up their balance sheet with mortgages during the good times. But to the degree that allowed them to build up retained earnings (i.e. capital), that is now providing additional cushion. Which is how the model should work, if regulators are doing their job.

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Steven Pearlstein: Afraid I've got to run. Good chat. "See" you all again soon, I hope.

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