Pearlstein: Fannie and Freddie

Washington Post columnist Steven Pearlstein was online Monday, July 14 at 11 a.m. to discuss the financial crisis and government-backed mortgage giants Fannie Mae and Freddie Mac.

A transcript follows.

Read his column from Friday and today's news that the U.S. plans to aid the mortgage giants.

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.

Read Pearlstein's latest columns.

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Clifton, Va.: Just let them fail and then reinvent them. Time to suck it up and let the economy just work things out without govt. intervention which delays the pain and suffering.

Steven Pearlstein: It is a fallacy to say that a rescue or whatever you call it "delays the inevitable." If that were true, it would not be worth doing it. Our experience is that when you get a loss of confidence like this, it is irrational and takes thing down too far (yes, markets were irrational on the way up as well). So if you can make the re-pricing of assets and the re-pricing of risk more orderly, you can avoid this kind of downward, reinforcing spiral, the vicious cycle, or at least slow it down so that the overdoing-it on the way down is minimized. That is why it is reasonable to intervene.

Put another way, these things have a dynamic to them that feeds on itself. A failure of Fannie and Freddie would absolutely bring the mortgage market, and the writing of new mortgages, to a half. That would drive home prices lower than they should go, relative to supply, demand, and incomes, at least temporarily, which would cause other lenders to fail unnecessarily, and so forth. So its not true that there is a predetermined "loss" that needs to be taken -- that we have to take our medicine and taking it now is better than dragging out the disease. That's really the wrong model, the wrong way to thing about these things.

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Chicago, Ill.: Hey Steve, two weeks ago you said calling the mortgage refinancing program a Wall Street bailout was a "mischaracterization". How do you reconcile that view with the fact that Bank of America largely wrote the legislation right after they bought Countrywide? By the way, Jamie Dimon agrees with you.

Steven Pearlstein: Not sure what you mean when you say Bank of American "wrote" the legislation. If you are referring to the housing bill that would allow FHA to refinanced troubled mortgages if lenders are willing to write down principal, let me say that I had a proposal on that in the Washington Post last September, and I never talked to anyone at Bank of American or any bank. It was a logical thing to do, and so lots of people came up with that idea. It certainly helped to get it passed that the industry was on board, but so were consumer groups and a number of academic experts.

The word bailout is not useful because people think it means making people whole -- lenders, borrowers, whomever. And that is not the case. Few people are made whole in any of these interventions, with the exception of bond-holders. Shareholders are almost wiped out. Lenders have to take a haircut in terms of interest rate and principal. Homeowners have their credit score ruined and, in the case of the housing bill, have to pay upfront fees, higher insurance fees and sacrifice some of the upside on the house appreciation when they sell. And, as I've said before, it is not clear that if the government handles this correctly, the taxpayer will wind up paying much at all, and may even make a profit if we are patient enough.

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Washington, D.C.: When is someone going to bail out the common everyday man?? We are pumping billions of taxpayer dollars into Fannie Mae, Freddie Mac, IndyMac Bank...but I can't get anyone to help me keep from losing my home to foreclosure? The economy is getting what it deserves for not stepping in when the house prices were skyrocketing higher than any normal person could afford. As long as big business made a profit, no one stepped in, but now that big business is failing, we are using my money again to save them. How does this help me in the long run?

Steven Pearlstein: Hey, fella. Who do you think is the primary beneficiary of this? Its the common man. The common man who has a mortgage. The common man who owns residential real estate. The common man who has his deposits in a bank that has its capital invested in "safe" instruments like Fannie and Freddie paper. If you want to see blood on the floor, let Fannie and Freddie default on its credit, and the world financial system will collapse in on itself. Trust me. And who do you think will have his lifestyle affected more by that, Donald Trump or the common man? So please, let's not turn this into class warfare. Nobody is doing this to "bail out" rich investors. People don't get rich buying Fannie and Freddie bonds. They are held by banks, pension funds, moneymarket funds, insurance companies -- intermediaries for the common man.

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Falls Church, Va.: It looks like this bailout is a done deal. Do we the taxpayers have any upside to this deal? Why not just let them fail? They have to change anyway so this provides the chance. How is this not them privatizing the profits and making the taxpayers cover the loss? Viewed through these agencies political activities over the last few years, specifically their campaign contributions, this situation looks almost criminal. Agree?

Steven Pearlstein: A certain columnist for the New York Times, who is a world-class economic and ought to know better, wrote this morning that Fannie and Freddie are just schemes to privatize gain and socialize risk. That's not precisely true, as you could have found out just by calling any Fannie and Freddie shareholder who has seen 90 percent of the value of his shares disappear in a matter of a couple of months. Right now, these companies are probably solvent enough to pay their many creditors but have very little left over for shareholders if they were to liquidate, and the stock prices reflect this reality. The reality could get worse, or it could, in the long run, get better. Nobody knows that. But the people who get the upside -- the shareholders -- have certainly not gone without suffering the consequences from the housing bust and the company's investment and lending decisions.

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McLean, Va.: Thanks for this and last week's chat. You are doing much good by spreading accurate information and not hyping the fear-mongering.

Steven Pearlstein: You're welcome.

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Bowie, Md.: Good Morning Steve. Just how stable are the top 10 investment banks? Certainly, the mortgage crisis has impacted others! Do you envision other runs on banks?

Steven Pearlstein: At this point, anyone would be crazy to assure you that no investment bank will suffer a "run" by having its short-term creditors pull the plug, leaving it without cash. These investment banks are complicated machines, but basically they borrow short and lend and invest long, so if their short-term funding is interrupted, and there is no government lending to fill in that gap, they have to declare bankruptcy and unwind/sell their loans and investments at distressed prices. The Fed backstop is meant to prevent that liquidity crisis. But let's be clear here: it cannot prevent a failure if, indeed, the long-term value of those assets are less than the liabilities. If the Fed gets a whiff that any of these banks is really insolvent, that is its assets won't be sufficient to cover its liabilities, then it will slam the window shut on such a bank and put it into some sort of receivership. That's why the Fed has people at all of these banks every day now.

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Philadelphia, Pa.: There are reports that several banks are in financial trouble. Insiders are drawing up lists and withdrawing their funds from these banks. Obviously the insiders wish to keep these lists to themselves and not set off panics, yet, may the public at large learn which banks are in financial trouble and may fail?

Steven Pearlstein: There are laws about that, and the FDIC, which insures deposits and takes over these banks when and if they fail, can go after people who trade on inside information to try to get their money out during the last days. They can try, but they will get caught.

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New lessons...: Hi Steven,

I'm watching all this with the fascination of someone who doesn't have a clue. I do however have two homes with fixed rate mortgages, a good job that covers both, and utterly no other debt so maybe I'm not so dumb.

At any rate, my point... By way of example, the FDIC was brought about to right the wrongs and the lessons learned from the crash that brought about the Great Depression - and so far seems to be doing its job. Do you see any other new programs that will come out of the new lessons learned here? It always seems to be, 'horse gone, lock barn door' - will something new and proactive come out of this?

I also find it interesting that the Fed is working so hard for a soft landing - why wasn't there more regulation to prevent the irrational upward climb as well? Or is it that the mo'money the better?

Steven Pearlstein: All good questions. We often do learn from these incidents, and come up with "fixes", but the next time, the excesses wind up being different and we repeat the mistakes in another guise. You are right to point the finger at the regulators, particularly the Fed, that didn't step in earlier when the lending was clearly getting out of hand and they were denying that there was a housing bubble and a takeover bubble and a credit bubble, generally. They could have reduced this problem if they were not so wedded to the ideology that the market is always right (or easily self-correcting) and that it is wrong for regulators to substitute their judgment for the market's.

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Tampa, Fla.: What happens to the bonds issued by FNM/FRE IF they do go under? Do they have enough healthy mortgage to repay the bond holders?

Steven Pearlstein: They probably do have enough healthy mortgages to pay them off, but just in case, the government effectively re-ntegrated its guarantee of those bonds yesterday evening.

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Perry, Kan.: Why does the federal government want authority to purchase stock in both? Is that a bailout for stockholders?

Steven Pearlstein: No, you can be sure it will be a bad day for shareholders when the government purchases that stock, which would probably be "preferred" stock. That means the government's investment is preferred over all others, which means if there is any money left after all the debts are paid, they get it. And the government would also get first call on any positive cash flow of the business for its dividend payments, before any other dividends are paid to any other shareholders. Basically, the stock will be valued at a very low amount when and if the government "invests" to provide a capital "cushion." That cushion is needed to assure the more important group, the bondholders/creditors, to continue lending money into the Fannie/Freddie machine, so they can continue to buy, package, insure and sell loans and keep the mortgage market in operation. Right now, they are buying about 80 percent of all conventional mortgages that are being written. They ARE the market, since all of their big bank competitors and private insurers and private label packagers have largely withdrawn. This is why Fannie and Freddie were invested -- to provide liquidity to secondary mortgage markets when the private sector, acting as a herd, withdraws, which it does every 20-30 years or so when there is a housing crisis.

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Alexandria, Va.: My solution is let us give another tax break to the rich. They can buy up the houses in foreclosure and save Fannie Mae and Freddie Mac. Wasn't that the theory about giving a tax break to the rich so as to create more jobs anyway? Let us have them save the foreclosed houses and job creation too.

Steven Pearlstein: You're joking, of course. But the sad thing is that there are still Republicans out there who believe in this witchcraft.

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Baltimore, Md.: "And, as I've said before, it is not clear that if the government handles this correctly, the taxpayer will wind up paying much at all, and may even make a profit if we are patient enough. "

Explain for the layman please?

Steven Pearlstein: What this has to do with, in the end, is the value of assets -- mortgages and mortgage-backed securities. And the value of those mortgages will depend on how many houses are foreclosed upon, and what those houses are sold for at foreclosure. Nobody knows. But if, by its limited intervention, the government can prevent massive numbers of houses from being dumped on the market at the same time, depressing the value of all homes, and can just hold on to these mortgages and houses until the market comes back, which it always does, then there need be no "loss" at all.

And what does the government do with a house that has gone into foreclosure. Here's one idea: rent it to the previous homeowner at the prevailing rental rates, while giving the homeowner an option to buy it later one, when prices rebound, with a solid, fixed rate mortgage that they can afford.

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Opportunity Knock, Kan.: Hi Steve.

Are FNM and FRE devalued stocks? Do you think now is the time to add both to one's investment portfolio?

Thanks.

Steven Pearlstein: I suspect they have been oversold, but I'm not going to suggest that any ordinary investors put their pension money in there. It is a high risk-potentially high return gamble right now.

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Anonymous: The Fed will allow FRE and FNM to put up their stock for cash at the discount window. The Fed will then have the option to buy an equity stake in both to stop stock price from collapsing. What a deal! Moral hazard be damned.

Steven Pearlstein: No, they can't put up their stock. They can put up their mortgage backed securities (bonds of a certain type) as collateral, just like most banks and investment banks can now do.

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20165: Fannie Mae has almost 50M in capital, and the government would not intervene until this capital reduces to 15M (1/2 the min 30M requirements). Also, many of Fannie's losses are paper losses based on the market value of MBS. Why is there such panic and hyperbole? I understand and applaud the government creating a plan, but why is the media painting this in strokes of an eminent bailout an insolvency of Fannie? Seems reckless.

Steven Pearlstein: There are those who, by using imprecise language and assuming the worst, have stoked fears unnecessarily. But lets not blame this one on the press, shall we?

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Arlington, Va.: Reason Congress did not investigate Fannie and Freddie and the reason for lack of oversight by the WH was not those evil Republicans but the fact Fannie And Freddie have a lot of ex pols working for them and most of them are dems!!!! Let them fail and combine Fannie and Freddie!

Steven Pearlstein: Until a few years ago, when they got into trouble because of their accounting practices, Fannie and Freddie used their considerable political influence to insure that they were not regulated as well and aggressively as they should have been. Their balance sheet was allowed to grow beyond what was necessary to provide liquidity to the mortgage market, which is their mission. No doubt about that. But it is not true that this situation was caused by lax oversight on the part of Fannie and Freddie's regulator. In fact, that regulator has been quite vigilant for the last three or four years, and even increased Fannie and Freddie's capital requirements. What has happened, unfortunately, is that we are in the worst housing market anyone has seen since the Great Depression, and the capital standards used by all regulators did not anticipate such an occurence.

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Atlanta, Ga.: I'm against govt. intervention way more than anyone - but I realize that I am getting nothing, I'm only paying for this.

From someone who has diligently paid off her mortgage - to the tune that in 8 years, I only owe half of what I paid for the house -and- I took on a total house renovation in that time.

No, I'm not rich (although Mr. Obama would probably say I am). And I live in a neighborhood where I can't believe the housing prices, even now - and yet there are definitely foreclosures.

So yes, I do know that I am definitely being helped by these 'bailouts.' So I do understand that and I'm not incredibly bitter. Except that I am not so happy with these people who still have their jobs, and are doing pretty well. Is anyone going to be hurting from this?

Steven Pearlstein: So far, nobody has been hurt by the government intervention, and lots of people like you have been indirectly helped. It is possible taxpayers will wind up paying something, although I don't think that is the most likely prospect. But if it does, the amount would be less than if the government had let these institutions fail because of a sudden loss of investor and lender confidence, and it brought down the housing market and the global financial system with it. THAT would really cost taxpayers, to a degree that would dwarf the cost of a rescue.

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Washington, D.C.: Steven, why do people keep making careless comment like Fannie and Freddie are insolvent? What are their motives, knowing that in this atmosphere, the market will react to their comments?

Steven Pearlstein: I wouldn't say there are careless, in that its hard to know how to value the balance sheet. These get to be very technical accounting issues, and there are various approaches, some of which would suggest the institutions are technically insolvent, others that would suggest they are well capitalized. The point is that there is no cash shortage right now, and won't be as long as Fannie and Freddie can continue to sell new bonds and mortgage-backed securities into the market they way they have always done.

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So please, let's not turn this into class warfare.: No need to turn it, it already is. Median wages DOWN over the last 8 years as the top 1%'s wealth skyrockets. College tuition and health care out of reach or getting harder to reach for most. Poor kids and lower middle-class kids fighting and dying in Iraq and Afghanistan. SS and Medicare underfunded. You're obviously a very smart man, but you appear to be living in bubble.

Steven Pearlstein: Yes, but that doesn't have anything to do with Fannie, Freddie and the government interventions.

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Atlanta, Ga.: With the government stepping in to save Fannie, Freddie, and Bear Sterns because their collapse would have such huge impacts, what keeps other extremely large companies from taking risks/making bad decisions in the future? Seems like the government is saying, if you're big enough to affect world-wide markets, we'll step in if you get in trouble.

Steven Pearlstein: That's why these institutions are regulated. And one thing regulators need to do is to make sure that, individually, people have as much downside risk as upside potential when they make these investment decisions, and that their profits and bonuses are held in escrow until the full consequences of their decisions are known.

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Laurel, Md.: OK, so the mortgage industry is one part of the economy in which we have to consider the "social benefit of its continued successful operation" as opposed to just letting a laissez-faire attitude dump on them.

Are there any other parts of the economy that the government should regulate (oil companies?) by saying "we wouldn't let your business fail if it was threatened to, so we have the right to make you act in a publicly-responsible manner?"

Steven Pearlstein: Finance is somewhat different. It provides the grease that lubricates the machinery of the economy and allows it to function, it provides the risk capital necessary for entrepreneurship and expansion, and it has become a very complex system in and of itself, which means it can suffer a breakdown if a major player sudden collapses.

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Collateral : Hi--As I listen to the coverage (not so much with responsible financial journalism, but on TV), the reports usually talk about the amounts of the endangered loans--but they rarely mention that these loans are secured by a house! Of course, the house is probably worth less than it was, but it's not worth zero--so a billion in loans is probably secured by no worse than $700 million, right?

Steven Pearlstein: That's right -- just because a loan is troubled, doesn't mean it is worthless. The riskiest tranche of a mortgage backed security may be worthless, but the safest tranches are worth 100 cents or 90 cents on the dollar once all is said and done. And there are tranches in between.

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Charlottesville, Va: Quick question: What do you mean by investment banks borrowing short and lending long? Just wanted to understand the flow of your logic.

Thanks, as always.

Steven Pearlstein: Investment banks rely on short-term loans to operate their business and even finance a good portion of the bank's own investments. That business, and those investments, often involve long-term investments, some of which cannot be easily and quickly sold without depressing the price drastically. So if short-term funding dries up, and they can't sell the corresponding assets for anything like what they paid for them, they are in a bind.

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Anonymous: Former Chairwoman of the CFTC, Brooks Born, warned of these "too big to fail" scenarios over 10 years ago. For this she was fired. Have you ever interviewed her?

Steven Pearlstein: Yes, and she wasn't particularly forthcoming, I might add. Not sure you have her first name correct. And I'm not sure she warned about a mortgage and housing crisis.

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Sterling, Va.: How much of an impact has the sophisticated innovations regarding financial engineering, particularly as it pertains to all kinds of derivatives, caused the huge rise, and now fall of the housing and credit markets? Do you foresee stricter guidelines regarding derivatives?

Steven Pearlstein: The market is correcting a bit for derivatives having to do with mortgage backed securities and firms that deal with them. But I don't foresee a whole lot of regulation in these areas beyond limiting the exposure of regulated entities like banks, insurance companies and, perhaps in the future, investment banks.

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Washington, D.C.: The broader picture of this is very confusing to me, so I am glad for your columns and chats!

My husband and I are looking for houses right now - we have to leave our current apartment, we don't want to move to another rental, we have money set aside for a down payment (through the FHA program) and closing costs and a cushion, we can afford a mortgage payment and other costs of home ownership, etc.

However, watching everything that is happening has me second-guessing our decision. Should we just continue to rent for one more year and ride this out?

Steven Pearlstein: If you can wait another year, I suspect you'll be no worse off and you may get your house for a lower price but at a higher interest rate on your mortgage.

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Annapolis, Md.: Anything that gets done needs to be accompanied by changes in the compensation structure of the executives who ran their firms into these problems. If we don't change the incentives we will continue having an endless cycle of bubbles that will make the people who caused them get very rich and the taxpayer will have to clean up after they crash. If that doesn't happen I would suggest not to give any help.

Steven Pearlstein: Completely agree. The compensation for Fannie and Freddie executives cannot and should not be tied too much to the change in stock price or the growth in earnings per share. And the people who invest in these companies ought to understand that they are not growth stocks and that there are times, like now, when the mission of the company is to provide liquidity to the mortgage market even if it is not the profit-maximizing strategy.

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Arlington, Va.: I understand [and support] why the Federal Govt. has to support, even bail out, Freddie/Fannie for overall good for the economy and credit/housing markets. What irks me is the vast amounts of money made by mortgage brokers and related interests who knowingly made very risky loans; as Bob Dylan says "some rob you with a six-gun, some with a fountain pen". They were rewarded and we the taxpayers get the bill. Is there any recourse against them?

Steven Pearlstein: If they engaged in fraud, there is recourse, although proving that can be hard and expensive. If they exercised bad judgment, but without defrauding anyone, then there is nothing to do except remember this the next time.

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Evanston, Ill.: Hey Steve, given the complexity of these issues, if we bailout now and put off any reform until the crisis is over, what chance will we have of implementing an effective counter-cyclical program? Won't the momentum and energy necessary dissipate if we wait until things are on the rebound?

Steven Pearlstein: Who's suggesting that we "bail out" now and reform later. The "bail out" will be now tacked on to a needed reform bill that gives Fannie and Freddie's regulator a lot of new powers and discretion, particularly over capital requirements and compensation.

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Falls Church, Va.: Isn't it time to explore whether the very existence of FNM and FRE has distorted the mortgage market too heavily? Since they have gone way beyond their traditional liquidity role in recent years, one has to wonder how much of the private lenders' retreat from the market is directly attributable to crowding out from FNM and FRE.

Notice, for instance, that the markets for car loans and credit cards don't seem to have dried up like mortgages have.

Steven Pearlstein: Yes, they grew their balance sheets unnecessarily (and profitably, it seemed at the time), but the private lenders retreat is not directly attributable to crowding out. In fact, during the bubble, Fannie and Freddie's market share actually declined and their balance sheet shrank as a result of regulatory pressure. As for those car loans and credit cards, watch out. They are the next shoes to drop.

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The District: "Steven Pearlstein: That's why these institutions are regulated."

Not very well. The point of regulation has to be to avoid catastrophic situations like this. When public monies are involved, the decision-makers have a civic responsibility to err on the side of caution. That wasn't done here; if it was, we wouldn't be having this chat.

Steven Pearlstein: True enough. But remember, even good regulation doesn't eliminate the possibility of a crisis, any more than a good flood control program eliminates all risks of a flood. If you take steps to make sure that even a 100 year flood does not damage, you probably overspend on flood control. That's why regulation is tricky and requires GOOD JUDGMENT.

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Steven Pearlstein: Time's up, I'm afraid. Thanks for joining us.

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