It is impossible to take a view on the bail-out of Freddie and Fannie without reference to the fear of systemic risk. The collapse of government sponsored enterprises (GSEs) that owe $7 trillion is quite unthinkable. The impact on market confidence would be catastrophic. What government would not have intervened, when jobless numbers are rising, the economy is faltering, there is little or no credit creation and foreclosures are rising?
That is the widely accepted justification.
Yet it still is hard rationally to explain Treasury secretary Hank Paulsons pre-emptive strike or to justify the nature of the bail-out.
By normal banking measures, Fannie and Freddie are probably insolvent. But these are not normal banks and their required capital ratios were not likely to be breached in the next year, or perhaps two.
No doubt the imminent US presidential election played a factor in the timing. Although nationalization might tie the hands of the incoming president, it spares the body politic from having to deal with a big financial crisis during that vote or between the count and the inauguration.
But that does not make it the right thing to do.
Proponents of the bail-out point to the critical role these entities play in providing mortgages at time when conventional banks are still de-levering and private label RMBS markets are shut tight. However, this line of reasoning and action risks repeating past policy mistakes.
For too long, sustaining the banking and real estate sectors has been a prime objective of monetary policy and the governments business policy.
Now it is has become part of fiscal policy. Taxpayers are firmly on the hook the bill for the subsidy that they previously enjoyed as consumers is about to be come due... with interest.
Having healthy banks and affordable mortgage finance is an admirable aim but the danger of using government policy to boost them in the face of a much-needed correction should be taken much more seriously.
Placing Fannie Mae and Freddie Mac under conservatorship, far from providing a cure for the sub-prime financial crisis, could even prolong it. Would the long-term interests of the US economy be better served right now by house prices stabilizing at current levels or correcting further? Will the renewed availability of low-cost mortgage finance protect householders or induce more unwise borrowers to acquire overvalued assets?
In addition to the conservatorship, the Treasury has earmarked $100 billion of capital injections for each GSE, protecting the positions of senior, subordinated note holders as well as GSE MBS. It will also purchase outright GSE MBS in the open market as well as making available a new liquidity facility separate from the Federal Reserves existing liquidity backstop for banks.
Superficially, as confidence-boosting measures, they were an immediate success as stocks rose and credit spreads narrowed although not for long.
This was a short-lived relief rally and the measures could be hugely expensive. Estimates that the cost will amount to $200 billion are highly optimistic and little more than guesswork.
Will that money buy the desired outcome? Housing downturns normally last something approaching five years. There is a strong possibility that the government has acted too soon and, furthermore, that the Treasury has left itself with little dry powder in an armoury already de-stocked by years of budgetary excess.
The key worry surrounds the government buying mortgage-backed assets directly; the prospect of the forced provision of finance to a sector in need of a deep correction.
What next? Will the government buy GM cars financed by GMAC? Will it insist that civil servants travel by United Airlines? Will it acquire the underlying assets of MBS the houses perhaps appointing a Soviet-style housing minister to manage the portfolio.
One thing is for sure. With this action, the US has lost all authority to make pronouncements on the rights and wrongs of other governments interventions in their markets or economies. It could also be a financial mis-step that Paulsons successors will come to regret.
In the first hours after the announcement, the CDS of the US government ballooned to 15 basis points. The concept of the US Treasury as a risk-free asset has come into question. And the socialization of this risk will have long-term consequences too.
Social intervention should be aimed at those in the greatest need can it really be said that the creditors of the GSEs meet that description?
Surely it is their fault that they did not demand enough yield to cover the lack of an explicit guarantee.