Don’t rescue Fannie, Freddie; remove them from the system

U.S. taxpayers will soon be active participants and financial stakeholders in the U.S. mortgage market, thanks to the Bush administration’s move to seize control of lending giants Fannie Mae and Freddie Mac. When a homeowner decides to walk away from their mortgage obligation, you and I will be obligated to help.

Fannie and Freddie buy mortgages from mortgage originators. They pool the mortgages and sell an interest in the mortgage pool in the form of bonds. The principal and interest payments from the homeowners pass-through to bondholders in the form of a payment. If some of the mortgage holders default or simply walk away, Fannie and Freddie guarantee principal and interest payments to the bondholders.

In the very near future, you and I as taxpayers will guarantee the principal and interest payments to the bondholders. You and I will stand behind what the New York Times referred to as “huge potential liabilities” that could cost the taxpayers “tens of billions of dollars.” How much could we be on the hook for? If we assume a 4 percent net loss on a loan portfolio of $5.2 trillion in Fannie and Freddie mortgages during the government’s watch, the taxpayers would conservatively be on the hook for roughly $200 billion.

Welcome to the mortgage business.

Mortgages carry risk. If you place a guarantee behind a mortgage-backed security, like Fannie and Freddie bonds, there really is no risk to the investors who keep supplying capital to the mortgage market. As investors supply more capital, more questionable mortgages can be written and builders can keep building more houses.

Placing a guarantee behind a risk asset creates moral hazards. Why? Because the loan originators do not care if the mortgage holder keeps making their payments since they can sell the mortgage to Fannie and Freddie, who in turn will place a guarantee behind the mortgage. If you remove those financial pledges, banks and investors would treat mortgages as risk assets, not a source of guaranteed revenue.

Instead of propping up Fannie and Freddie with taxpayer funds and guarantees, both firms should be gradually removed from the system, an option which is still open to policy-makers. The free market can supply mortgage capital to people who have the necessary debt-to-income ratios and credit history. The current state of the mortgage and housing markets clearly illustrates the results of placing guarantees behind risk assets. Fannie and Freddie are part of the problem, not part of a solution. Selling a house to someone who cannot make the payments is not helping anyone, and certainly not helping anyone live the American Dream.

This bailout also sends a clear message that things are bad and they are likely to get worse before they get better. More foreclosures are coming, which means more problems lie ahead for banks and brokerage firms. The government’s intervention will moderately improve the availability of mortgage credit, but it does not directly address the core economic issue of supply and demand in the housing market. As long as the supply of homes remains high, prices will continue to fall. Based on history, we can expect some hope when the inventory of unsold homes falls to a 6-month to 7-month supply. We now have a 10-month to 11-month supply of unsold homes.

Even if home sales increase, sales at lower prices mean continued deterioration of the value of assets held on bank balance sheets. As a result, banks will continue to be in need of capital injections, triggering more write-offs. Banks will then remain reluctant to extend credit.

Tight lending standards are not good for an economy which is highly dependent on credit. Tight lending standards mean fewer buyers for all goods and services. Fewer buyers lead to a weaker economy. A weaker economy leads to more job losses. Job losses lead to more mortgage defaults … and around and around we go until the supply of homes is reduced to a reasonable level.

The government’s takeover of Fannie and Freddie does not make things much better, but it does prevent them from getting worse in terms of further constraints on Fannie’s and Freddie’s ability to support the mortgage market. While this may be good news for short-term stock traders, it is most certainly bad news for longer-term investors and taxpayers.

> Chris Ciovacco is CEO of Ciovacco Capital Management in Atlanta.