Cavagnaro Blog (updates and occasional rants): Issue #2: What to do with Fannie and Freddie

From today's Wall Street Journal:

The two companies [Fannie Mae and Freddie Mac] were chartered by Congress to support the housing market, and therefore were seen as having the backing of the government. That allowed them to borrow funds at favorable rates close to those of U.S. Treasurys, even though they are both profit-making entities answerable to shareholders.

Sen. John McCain, the Republican nominee for president, has said his goal is to make the companies "go away" and to push for regulation that "limits their ability to borrow, shrinks their size until they are no longer a threat to our economy and privatizes and eliminates their links to the government." Sen. McCain supported giving Treasury the authority to backstop the firms but has said any use of taxpayer funds should be combined with an ouster of management and a ban on lobbying by the companies.

Sen. Barack Obama, the Democratic nominee, has said the companies are a "weird blend" and that "if these are public entities, then they've got to get out of the profit-making business, and if they're private entities, then we don't bail them out."

Way to go Obama. "If this then that...else, if this then that...but they are both...a blend" ...uummm...what? I will give it to him that he articulated the two options in a way that a common person can understand but he doesn't take a side. All he had to say was..."And I believe it is a public entity at heart" and he would have gotten a gold star...but he didn't. God it must be great to be followed by hoards of people who don't really listen.

While one can debate if McCain's position is right or wrong...at least he takes a stand. Unfortunately, I think he is only "mostly" right. I think all he missed was a clarification that it be privatized into a non-profit corporation...a "Mortgage-For-Humanity" approach. A place where decent people simply try to match investors with home buyers in a responsible manner and uses the profits to keep the operation running.

But what the hell do I know....I don't have a PhD in Keynesian economics. Go GIANTS!

Breakdown of McCain's statement (I will leave Obama's alone):

Agree: We need to keep them from going under (they hold $5 trillion in debt after all...it iwll hurt you...see below).
Agree: We need to cut off their lobbying power ($170 million over the past decade)
Agree: Limiting their ability to borrow would lower the risk to more acceptable levels (see below)
Missing: Require minimum lending standards to again lower the risk to more acceptable levels (see below)
Mixed: "Shrinking their size" will probably not help much since that will either directly hurt the consumer (higher cost loans or harder to obtain loans) or force more of the $$ for loans into uncontrolled outlets.
Mixed: Eliminating their link to the government sounds good but I do not agree that it can be completely privatized since Shareholder pressures could be re-introduced in that situation.

"Simple" view of how this works (at least my understanding):

YOU go to Bank A and you borrow ~$100K.
Bank A gives you $100K expecting that you pay it back over 30 years with interest.
But the bank is now unhappy because they don't have any more money to loan.
So they "sell" the loan to Company B and Company B gives them $100K plus a little extra something for the effort.
Now Bank A is happy (have cash again) and YOU are also happy in your new home.
Company B is also happy because they got their $100K for 4% and you are paying them %6 and they get to keep the difference. That is...as long as you keep paying.
If the story stops here then we all live happily ever after.
But then the shareholders of Company B get unhappy because they aren't making enough money.
So Company B decides to bundle $Ms of these mortgages together and sell them to Investor C as dividend generation securities. This allows them to get more cash to lend back to Bank A.
BUT, Investor C is not dumb. They want assurance. If YOU stop paying your loan then they still want to get their fixed income from Company B.
Ahh, Company B says...we can guarantee that for you...no worries. Thus Company B is ultimately left holding the bag if YOU stop paying off your loan.
If the story stops here then we all live somewhat happily ever after.
But then the shareholders of Company B get unhappy because they aren't making enough money AND the government is also encouraging them to be more aggressive cause things are "slowing down".
In response, Company B continues to become more aggressive with it's risk profile to continue to fuel returns. They do this in two different ways. First, they increase their debt:equity ratio...meaning they lend out more and more money vs. what they actually have. Second they start taking on riskier loans (i.e., sub-prime).
Finally you start approaching a point where so many people are not making their payments and Company B is no longer able to keep paying Investor C.
Now you have a problem because Investor C can be anyone from an over-seas government to your local teacher's pension fund...and not paying the retired teachers is a bad idea...especially if you are a Democrat.
Thus the taxpayer needs to step in and cover the gap. And the big wheels keep-a-turnin'.