Bailout: Why, why now and what next?
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Bob Moon: It’s official: The giant mortgage underwriters Fannie Mae and Freddie Mac are being taken over by the government. The move could potentially cost taxpayers $200 billion, but it could also help reverse the housing and credit crisis. Treasury Secretary Henry Paulson says the cost of allowing the companies to fail could take an even higher told on our wallets.
On the line to help us understand this move is Thomas Stanton, who teaches about Fannie and Freddie at Johns Hopkins University. Thanks for joining us.
Thomas Stanton: Sure, glad to be here.
Moon: Why did the government have to take this action and why now?
Stanton: The government had to step in because Fannie and Freddie were undercapitalized and were under immense stress. And what we’ve learned from past bank and savings and loan failures is that when management comes under that kind of pressure they may feel the need to do something imprudent, take a big risk to try to recoup their losses.
Moon: Has the government maneuvered correctly here? This seems to be a pretty delicate dance.
Stanton: I think the government has done an excellent job. Secretary Paulson has essentially stepped in and figured out a way to reassure both the financial markets — and particularly foreign investors in Fannie and Freddie’s debt obligations, mortgage-backed securities — and also assure that Fannie and Freddie continue to provide and be a conduit for federal support. There’s a second step to this process. The business model of this half-public, half-private government sponsored enterprise has failed us and failed us pretty badly. The Treasury’s power to do what they’re doing go away Dec. 31, 2009. Secretary Paulson basically tossed the problem back to Congress and said, “Congress, you have got to decide where we’re going with these two huge multi-trillion dollar institutions.”
Moon: So, there’s this question hanging out there, what happens now? Let me run past you something Secretary Paulson said.
Tape of Secy. Henry Paulson: It would not have been in the best interest to the taxpayers for the Treasury simply to make an equity investment sin these enterprises in their current form.
Moon: And he went on to say there’s a consensus cannot continue in their current form. Doesn’t that kind of insure that share prices aren’t going to do well now, because investors have to keep wondering and worrying about the future of these two firms.
Stanton: Investors in Fannie Mae and Freddie Mac really enjoyed the benefits of immense leverage that these companies had. In 2002, and this is an extreme example, Freddie Mac recorded a return on equity of 47 percent. Leverage was great when things were good and now investors have gotten hurt by the leverage when things are bad. It just moves in reverse. Shareholders are in a little bit of trouble here and that’s because they invested in thinly capitalized companies that took on a huge amount of risk.
Moon: Thomas Stanton of Johns Hopkins University, thank you for joining us.
Stanton: Thank you.