Treasury's Takeover of Fannie & Freddie

As I wrote in this recent post, there really is a lot less than meet the eye to the necessary consequences of the weekend's takeover by Treasury of Government Sponsored Entities and mortgage finance conduits Fannie Mae and Freddie Mac.

The bare minimum action required in this market situation is for Paulson's Treasury to stand behind the value guarantees of any of the GSEs' issued mortgage-backed securitization instruments. That is, to assure the same level of valuation implied by the original government backing, regardless of whether Fannie or Freddie exist.

I checked with my mortgage banking veteran friend B this morning, by phone, to see if I had missed anything. His most recent views on this mess were presented in this post, written almost two months ago, which featured an email of his to me, pasted verbatim.

Despite much public hand-wringing, including a local radio station's excited headline at 6AM this morning that,

'the Treasury stepped in to rescue the two mortgage companies in order to prevent the collapse of financial markets and, quite possibly, followed by the US economy,'

the only real crisis, as Paulson articulated in his public comments, was that of investors, including foreign governments and institutions, losing confidence in the US government guarantee of Fannie and Freddie securitized instruments.

The continued operation of both firms as conduits for securitizing mortgage loans really isn't a critical issue right now.

Again, despite breathless questions on CNBC this morning of a Republican House member who is voting against the takeover as to what he would say,

'to a constituent of yours who is just out of reach of a mortgage now, thanks to this takeover failing and the mortgage markets seizing up,'

I don't see that as a problem. Neither does B. He warns me that it is a political issue how to clear out the GSEs from the conduit business, in order to usher back in private sector players.

But it's not an economic one. And, again, contrary to CNBC's 'task force' which worried on air about whether or not the mortgage securitization business should exist, let me make something clear. Just because a poorly-run pair of GSEs messed up in no way means it is an unattractive, nor unnecessary market activity.

But it clearly is not one to be performed by Fannie, Freddie, or anything structured like them.

High quality, 20% mortgages are still being made in the US. These were the backbone of the sector for decades. Problems arose when sector executives decided to stoke growth by reducing the percentage of downpayments they would accept for mortgage loans. When the downpayments became too lean- probably somewhere between 5-10% - the model failed. Housing prices dipped by more than the downpayments, wiping out the owner's equity in the home, and triggering defaults.

But this isn't a function of Fannie or Freddie, per se. It's the fault of private-sector, publicly- and privately-owned banks.

The existence of Fannie and Freddie really have little to do with this. Sure, they took the resulting mortgages and securitized them. But bankers made the loans to begin with.

If the mortgage securitization business has been poisoned by the bankers themselves, due to bad risk and growth management in the past decade, then they have nobody else to blame for the moribund market. B thinks it may indeed, as I surmise, be at least five years before private conduits can flourish in the wake of Fannie and Freddie.

Until then, US mortgage finance may temporarily return to the old days of local and regional financing.

But, until all the weak and badly-managed players are gone from the sector, investors won't touch mortgage-backed securities anyway.

All the more reason for Paulson to kill off the GSEs entirely, as I argued in that first linked post from last month. Guarantee the securitized instruments, pay off the GSE bond-holders, pro-rata if necessary, then leave shareholders with the remainder, if there is any.

In time, if it's profitable, mortgage securitization will be provided by good-quality banks by selling off their portfolios of mortgage loans again, like they used to before Fannie and Freddie began increasing the sizes of the mortgages they accepted, and gobbled up so much of the securitization market.