What will we do if the big two go bust?

January 4, 2008 – 9:21 am

by Rolfe Winkler, CFA

Pasted below, a copy of the op-ed I published in today’s Baltimore Sun.

What will we do if big two go bust?

By Rolfe Winkler
January 4, 2008

They don’t know it, but taxpayers stand to lose billions as the housing bubble bursts. And in a bipartisan effort to “do something” to save the housing market, President Bush and the Democratic Congress appear set to put taxpayers on the hook for billions more.

Until now, losses in the housing world have been confined to homeowners, mortgage lenders, banks and investors in toxic mortgage securities. But by virtue of the implicit federal guarantee backing mortgage giants Fannie Mae and Freddie Mac, U.S. taxpayers may be one of the largest mortgage lenders in the world – set to lose billions, like all the others.

Between them, Fannie Mae and Freddie Mac back more than $4 trillion in mortgages. If they fail, it could force an unprecedented taxpayer-funded bailout. And they are much closer to failure than most people realize.

Some saw this coming, including presidential candidate Ron Paul. As far back as 2002, Mr. Paul – whose candidacy I’m not actively supporting – predicted the Federal Reserve would blow up the housing bubble.

Besides the Fed’s low-interest-rate policy, which encouraged excessive borrowing to buy homes, its refusal to regulate mortgages gave lenders license to sell whatever mortgage products they could dream up, no matter how risky. Mr. Paul was dead-on with his prediction that the Fed was blowing a new bubble and that it would burst violently.

Another Paul prediction, that Fannie and Freddie will go bust, forcing a taxpayer bailout, remains controversial because few think the housing crash could be that bad.

But consider how vulnerable Fannie and Freddie are.

In a recent Securities and Exchange Commission filing, Fannie noted that it backs $2.6 trillion worth of single-family home loans. Underneath this pile of debt, the company has only $42 billion of capital. If the value of mortgages backing Fannie’s debt falls a few percentage points, the company’s capital could be wiped out. And because of the implicit government guarantee backing Fannie’s debt, American taxpayers would be on the hook for whatever debt Fannie couldn’t cover.

To be sure, most mortgages that Fannie backs are safe. But consider Fannie’s exposure to high-risk loans: about $300 billion of stated-income “liar loans,” $200 billion of interest-only mortgages, $120 billion of subprime mortgages and $330 billion of high loan-to-value mortgages.

Some of these high-risk loans fall into multiple categories and shouldn’t be double-counted, but you get the picture: Fannie has significant exposure to high-risk loans and only a small capital cushion to protect itself.

Freddie Mac has a few hundred billion dollars of high-risk loans in its $2.1 trillion book of mortgages. And Freddie’s capital cushion is a meager $40 billion.

Each has reported billions in losses, and they will report billions more as foreclosures accelerate across the country. What happens if their problem loans fall so far in value that their capital is wiped out? There’s only one bank large enough to take over Fannie’s and Freddie’s debts: the U.S. Treasury. Taxpayers.

Yet despite the substantial risk facing Fannie and Freddie, many in Washington want the two companies to back more and bigger mortgages in a shortsighted attempt to blunt the impact of the housing crash.

In 2005, Mr. Paul introduced an amendment in Congress to end the implicit taxpayer guarantee backing Fannie’s and Freddie’s debt. He said at the time: “I hope my colleagues join me in protecting taxpayers from having to bail out Fannie Mae and Freddie Mac when the housing bubble bursts.”

At this point, Fannie’s and Freddie’s positions are too precarious to remove the federal guarantee backing their debt. Doing so could lead to more trouble in the housing market and panic in the financial market.

Future damage can still be contained, however, if we do two things. First, we must demand tighter regulations that limit Fannie’s and Freddie’s overall mortgage portfolios. At the same time, we must not allow Congress to increase the size of mortgages Fannie and Freddie are allowed to securitize.

It’s a shame others in Congress weren’t listening to Ron Paul in 2005.

Rolfe Winkler, a CFA charterholder, is publisher of OptionARMageddon.com.

  1. 8 Responses to “What will we do if the big two go bust?”

  2. Some of the GSEs, such as Fannie Mae and Freddie Mac, are privately owned but publicly chartered; others, such as the Federal Home Loan Banks, are owned by the corporations that use their services. Their lenders grant them favorable interest rates, and the buyers of their securities offer them high prices, as the implicit involvement of the Federal government gives them a sense of financial security.

    In fact, GSE securities carry no explicit government guarantee.

    By pengbert on Jan 7, 2008

  3. That’s a good thread for discussion: what WOULD happen if Fan/Fred become insolvent and the government DOESN’T bail out their debtholders?

    In my mind, the “implicit” guarantee is enough to put taxpayers in danger. Can you imagine the financial carnage if FNM/FRE go bust and the government backed off its implicit guarantee? You’d have a run on Fannie/Freddie bonds and the whole mortgage-backed securities market, and by extension mortgage finance in general, would be in serious jeopardy.

    By RW on Jan 7, 2008

  4. I think that FDIC (Federal Deposit Insurance Corporation)is the same. It is only has implicit government backing.
    This statement:
    “full faith and credit of the United States Government stands behind the Federal Deposit Insurance Corporation and its deposit insurance fund.”
    is a political statement not a legally binding statement.

    - Arlen

    By Arlen on Jan 7, 2008

  5. God forbid that you would actively support a Ron Paul candidacy just because he has been right on every issue facing the American public this election year!

    By Dennis on Feb 16, 2008

  6. Ron Paul. As far back as 2002, Mr. Paul – whose candidacy I’m not actively supporting ……….
    Why the negative? The article was very good other than that!
    So everytime you quote a politician you make sure you note I supported this guy or I don’t support this guy?
    Well not by the other articles I have read of yours! You just quote them or mention them! So why the Ron Paul snide remark? Rolfe Winkler I have read a few of his articles he seems to hit the nail on the head — but he is a writer that I don’t actively read!
    Seems kinda weird don’t it?

    By so-n-so on Feb 17, 2008

  7. we have long followed been aware of the subjects we hear from Dr. Paul…In this diffcult time of sorting truth from fiction and of re-assessing previously held positions, it is curious to us that you hold Dr. Paul to such a strict standard when he supposed previous positions are all contained in ‘newsletters’. Why not look to his ‘talk the talk and walk the walk’ congressional votes and submitted legislation – no other candidate in either party has such an illustrious committment to the constituion, smaller goverment and personal responsibility – they only know about ‘pandering’! Marie White, Arkansas

    By Anonymous on Feb 17, 2008

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  2. May 29, 2008: Option ARMageddon » Blog Archive » NYT: Fannie/Freddie fears spreading
  3. Jun 1, 2008: Option ARMageddon » Blog Archive » The "Reflation" Solution?

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