Monday, September 18, 2006

Blaming the system

The Bush Administration has backed off an ambitious plan to change the fundamental nature of Fannie Mae and Freddie Mac and now seems to be settling for relatively minor changes in how the two mortgage GSE's are regulated.

This probably reflects a political reality that the White House needs to pick its battles (no pun intended). Their original plan was an attempt to reduce Fannie and Freddie's considerable market power by forcing them to reduce the size of their mortgage investment portfolio. There was also talk of eliminating the symbolic credit line the two have with the Treasury. This would have further reduced the power of the GSE's, because it would have decreased the funding advantage they have over competitors like Washington Mutual and Countrywide.

While I suspect the change of heart has more to do with politics than economics, I don't think this is the time to be tightening regulations surrounding the mortgage GSE's. Whatever you think of Fannie Mae and Freddie Mac, they undoubtedly reduce mortgage rates, which supports housing prices. The housing market could use all the help it can get right now.

The Administration's stated long-term goal is to reduce the systematic risk posed by Fannie Mae and Freddie Mac. Systematic risk is a hard thing to get a handle on. I think we can all agree that if one GSE is bankrupt, not only would the other likely be in deep trouble, but many banks around the world would also likely be in trouble. The economic event that causes one of the GSE's to go bankrupt would also cause serious problems for all sorts of financial institutions.

But I wonder whether the contagion effect has much to do with Fannie Mae or Freddie Mac being so large? I mean, say we have a 40% decline in home prices around the country, leading to massive defaults, and eventually toppling the mortgage GSE's. The problem in that scenario isn't that Fannie Mae or Freddie Mac are so large, the problem is we had a housing market bubble. The systematic risk is that housing is such a large percentage of total assets in the U.S. I don't think there is anything you can do to the GSE's to resolve that issue.

On the other hand, what if one of the GSE's suffers a Barings Bank-type collapse, that doesn't have anything to do with broad economics. That might wind up being costly if the Treasury has to bail them out, but would it really be as bad as the S&L crisis? Or LTCM? The solution may wind up being similar to LTCM. Long-Term's problem was not their positions as much as it was their leverage. The Fed orchestrated a buyout of Long-Term's assets by various Wall Street firms.

If Fannie or Freddie went under because of a rouge trader, it would be pretty similar. You'd have a large pool of well-performing assets that needed to be liquidated to cover losses in other investments. In order to prevent a contagion in the mortgage market, some scheme would need to be developed to liquidate the assets in an orderly manner. But because an orderly liquidation would be in every one's interests, just like it was in the LTCM case, something could surely be worked out.

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