Paulson’s pluck

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Sep 11th 2008 | WASHINGTON, DC
From The Economist print edition

The “conservatorship” of Fannie and Freddie may soothe America’s economic woes, but it will not solve them


HANK PAULSON has earned himself a place in the record books as the Republican treasury secretary who engineered the biggest nationalisation in modern American history. It may be called a “conservatorship”, but the seizure of Fannie Mae and Freddie Mac is, in effect, a government takeover. Whether this boldness improves the outlook for America’s economy depends on the answer to two big questions. First, will government control of Fannie and Freddie help solve America’s housing mess? Second, would stability in the housing market be enough to turn around the economy?

The answer to the first question is a qualified yes. It is hard to overstate Fannie’s and Freddie’s importance in the housing market, both as holders or guarantors of half of America’s mortgages, and as lenders who have stepped in as private finance has collapsed. Over the past year they increased their lending by about $600 billion, or 12%, and this year they have financed four out of five mortgages. Without this cushion America’s housing bust would be far worse.

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The conservatorship places restrictions on how fast Fannie and Freddie’s loan book can expand but not on the pace at which they can extend guarantees. After 2009 it demands that their portfolios shrink, but in the short term Mr Paulson’s takeover is meant to make mortgage finance flow more freely and cheaply. What is more, the Treasury said it would buy mortgage-backed securities. The impact on borrowing costs was swift. On September 10th the average rate on a 30-year mortgage was 5.79%, almost half a percentage point below the average rate of 6.25% the previous week. In effect, Mr Paulson engineered the equivalent of a half-point cut in interest rates targeted at the mortgage market.

If it lasts, easier access to cheaper finance ought to help boost housing demand, particularly since the plunge in house prices has improved many measures of housing affordability. According to the S&P/Case-Shiller national index, America’s house prices have fallen by 15% in the past year. That is the biggest decline in The Economist’s house-price index (see chart). The vast overhang of unsold homes (more than 11 months-worth of supply at July’s pace of sales) coupled with accelerating foreclosures (which rose at their fastest pace in three decades between March and June) means that prices still have further to fall. But lower financing costs and stronger demand will help staunch the decline.

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What about the broader economy? Since mortgage losses are at the heart of banks’ financial woes, softening the housing bust would help. Shoring up Fannie and Freddie will also compensate for tighter credit elsewhere. But the takeover will not avert the deleveraging that has hardly started. In a paper presented at the Brookings Institution, Jan Hatzius of Goldman Sachs predicts that house prices will fall by a further 10% and that overall mortgage-related losses will eventually reach $636 billion. Even with Fannie and Freddie continuing to lend, he reckons the credit crunch will knock 1.8 percentage points off GDP growth.

Moreover, the economic picture was growing more gloomy even as the Treasury was plotting its takeover. Consumers’ troubles are mounting as the boost from fiscal stimulus fades and the labour market worsens. The jobless rate soared to 6.1% in August; with falling asset prices and tighter credit making it harder for consumers to borrow, lost paychecks will have a more immediate impact on their consumption. Falling oil prices may bring some relief at the petrol pump, but gauges of chain-stores’ sales suggest that consumer spending is flagging. Under such circumstances, the government is right to take bold steps. But even interventions on the scale of Mr Paulson’s may not be enough to raise people’s sagging spirits.