Thursday, August 21, 2008

Fannie and Freddie or Phonie and Fraudie?

As equity values for Fan and Fred plunge and the stock prices become optically embarrassing (e.g., Freddie is now a $3.16 stock with a $2.0B market cap), it is worth asking "so what?"

So what if they are nationalized? What's the downside?

Some equity holders get wiped out. Who cares? Freddie has a $2 billion market cap; a year or so ago, it was about $40 billion. So the damage is already done on that front. The remainder is just a rounding error.

What else happens? Well, the preferreds will get wiped out and the sub-notes may as well. But that's fine. Corporate bankruptcies happen regularly and the owners of those securities accept that risk. The senior notes will be made whole by you and me via our government's now explicit enough guarantee. So our foreign creditors will be fine (in fact, they'll be better off than they are today while credit spreads remain wide for the GSEs).

What about fear? Won't the "collapse" of the GSEs engender an enormous amount of fear which could lead to widespread financial collapse? Well, no. The reality is that the vast majority of our citizenry has no idea who Fannie and Freddie are, much less what they do. Nobody has deposits and Fannie and Freddie. The GSEs don't have any retail branches. Nobody has a mortgage directly originated by Fannie and Freddie. The reality is that most people are never going to directly "touch" Fannie or Freddie. So, their disappearance will not cause an obvious change to life for most folks.

Won't the cost of financing a house rise? Barring the federal government continuing to aggressively operate the GSEs, yes, borrowing costs will rise. This will happen and it will obviously put pressure on house prices. A conforming 30 year for a decent credit with 20% down is going for about 6.3%. A jumbo prime (eg, a $1 million loan) with 30% (not a typo) down is going for 8.5%-9.0% these days. So, yes, financing costs and standards will likely rise. However, all this will do is eliminate a silly and unnecessary subsidy.

There will be a one-time nationwide home price adjustment, but I want to be crystal clear, Fannie and Freddie DO NOT MAKE HOME OWNERSHIP MORE AFFORDABLE (same goes for the tax deductibility of mortgage interest). While they artificially push the rate on a given mortgage down, all that does is artificially push the price of a given house up until the all in financing cost is basically neutral. While that one time reversion will be a painful experience for existing owners, it is not the government's place to provide a house price subsidy that clearly a) is adding to systemic risk and b) makes each new home buyer more and more trusting of those falsely inflated prices.

My strong suspicion is that the gov't will do everything in its power to prevent this change despite it being a logical step on the road to recovery.

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