Mortgage Giants Need Dose of Reality

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Last week’s announcements of first half results from Fannie Mae and Freddie Mac exposed the dire straits they are in. By its own rosy fair-value accounting, Freddie is already insolvent. Fannie is in better shape, but a string of heavy losses may have left it fatally weakened. Since both anticipate falling house prices through 2009, their futures grow blacker by the day.

A collapse of Fannie and Freddie would be a huge blow to an already-comatose housing market, so Washington is in full panic mode. Last month, Congress and President George W. Bush pushed through emergency legislation authorizing Treasury Sec. Henry Paulson to supply federal cash infusions of up to $300 billion to the mortgage giants, in almost any form he chooses.

Illustration by: Matt Mahurin

Paulson says he has no current plans to use that authority. But there is no possibility that he could allow a default on senior Fannie and Freddie debt. It is widely held by foreign central banks, and U.S. officials, including Paulson, have consistently reassured holders when doubts about the reality of the guarantee have surfaced.

But if the government is forced to bail out Fannie and Freddie, many other important decisions would have to be made. How do you treat the shareholders, or subordinate bond holders? How much can you curtail Freddie and Fannie without trashing the economy? Do we need a Fannie and Freddie at all? A fundamental question is why is the government propping up house prices amid a glut of unsold houses.

The bitter truth is that by conventional measures, like the ratio of house prices to rentals or to incomes, prices are still too high. Home prices nearly tripled over the eight years from 1998 to 2006, but have so far fallen only by about 18 percent.

There is a growing consensus that prices will fall by another 15 percent or so. The projections made by Fannie and Freddie economists, though they use different market indices, anticipate proportionally that level of decline — bottoming out toward the end of 2009. Even generous federal refinancing programs for home mortgages make little sense when prices are dropping. Working people would be better off renting instead of being chained to falling assets.

Officially, we classify residential housing as an “investment.” Sometimes that’s true. The shift of the nation’s economic center to the technically dynamic Southeast and Southwest in the 1980s and ’90s was possible only with vast new housing and infrastructure construction.

But the “McMansions” at the heart of the 2000s construction boom look like economic millstones, their wraparound entertainment centers and multiple bathroom-spas monuments to conspicuous consumption. Big houses on large lots are energy hogs – both heating and driving – and impose heavy additional costs extending local sewage, sidewalks and other amenities.

A cold-eyed view of Fannie and Freddie suggests that they’ve long since outlived their usefulness. This is a country with low personal savings, extraordinarily wasteful consumption habits and big deficits in pensions, health care, roads and airports. Yet the new housing bill raises their permissible guarantee ceiling from $417,000 to $729,750 — as if bigger houses were a national priority.

A realistic approach to a collapse of the mortgage giants might be: Federalize their outstanding senior debt, upholding the implicit guarantee. Recognize all their likely losses in fell swoop, which will wipe out current shareholders. (The taxpayer owes no obligation to investors who let their company run rampant.) Then create a new federal entity, with a high-quality board of directors, to run off the existing business in an orderly way, perhaps over the next 5-10 years, to minimize market disruptions.

The total effect would be to increase mortgage rates, and force new buyers to build more savings to become mortgage-eligible. Consumption of big-ticket furniture and electronic appliances would probably drop. None of those is a bad thing.

From 2000 through 2007, the United States spent 105 percent of what it produced. The resulting trade deficits have put some $5 trillion into the hands of foreigners, so the dollar has been falling and commodity prices spiking. Worse, a huge share of the overseas dollar trove is in the hands of states like Russia, China and the Middle Eastern petro-kingdoms — which have little love for the United States, and often shadowy ties to terrorism.

Everyone knows that we have to change our ways. The way we deal with Fannie and Freddie will show how serious we are.

• Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”*