Help is at hand

tauringhuang.

Jul 28th 2008 | NEW YORK AND WASHINGTON, DC
From Economist.com

Congress passes a bill to assist homeowners and to rescue Freddie Mac and Fannie Mae

AP
THERE is nothing like the prospect of financial Armageddon to concentrate minds. In recent months wrangling in America’s Congress over legislation to help homeowners caught up in the mortgage crisis has been typically tortuous. But even the most inveterate horse-traders were spooked by the stomach-churning falls earlier this month in the share prices of Fannie Mae and Freddie Mac, the country’s government-sponsored (but privately owned) mortgage giants, amid fears over mounting credit losses. The Treasury reluctantly proposed a bail-out for the firms, which was tacked onto the housing bill. Politicians rushed to reach a compromise.

On Saturday July 26th the Senate overwhelmingly approved the mammoth package, as the House had done a few days earlier. George Bush is expected to sign it into law this week. The bill is the most important attempt yet by Congress to stabilise financial markets and alleviate the pain felt by borrowers. Its centrepiece is authorisation for the Federal Housing Administration, a government agency, to guarantee up to $300 billion of refinanced mortgages for borrowers who could lose their homes. Participating lenders must accept 80-90% of the home’s current value. In return for more relaxed loan terms, borrowers will have to pay the government a 1.5% insurance premium.

The bill also includes a host of lesser measures, some controversial. Right-wingers are none too pleased with a new affordable-housing fund, designed to create more rental homes. Nor are they thrilled with a $4-billion handout for local governments to redevelop foreclosed properties. There is broader support for a provision setting greater oversight of mortgage brokers, whose warped incentives played a part in inflating the subprime-mortgage bubble.

But it is the measures concerning Fannie and Freddie that carry the biggest implications and have generated the most bile. The government is now making explicit its implicit (and oft denied) support for the mortgage giants. The Treasury will get temporary authority to extend unlimited loans to the firms or to purchase equity stakes in them if their condition worsens. Better late than never, Fannie and Freddie will also get a regulator with sharper teeth.

Fannie and Freddie, with more than $5 trillion of held or guaranteed mortgages, almost half of the total American market, were simply too big to fail. As they grew, they strayed from their core business into putting their names behind hundreds of billions-worth of subprime mortgage-backed securities cooked up by Wall Street. Largely thanks to this foray they are now insolvent, or close to it, by most “fair-value ” measures (based on current market prices). “Like Enron on steroids” is how one critic, Dick Armey, characterised the combination of reckless expansion, questionable accounting and ferocious lobbying.

The big unknown is the tune to which the taxpayer is now on the hook. Perhaps not at all, if explicit public support succeeds in calming nerves and the firms can raise the extra capital they need. But further large losses are possible. Ominously, the housing bill raises the federal-debt limit by $800 billion, to $10.6 trillion, to pay for any aid that may be needed. In the short term the rescue may have averted financial apocalypse. Over the longer term the price could be steep.

Like a hard-living student who relies on his parent to cover his debts, Fannie and Freddie will at the very least have to change their ways. As Joseph Stiglitz, a Nobel laureate and Columbia professor, puts it, being too big to fail doesn’t mean being too big to be reorganised. Their dizzying leverage will have to come down, for one thing. There will be little appetite in future for such hybrid entities, whose profits are private but whose risks are socialised. Calls for the firms to be nationalised or broken up will surely grow.

That may have to wait, if mortgage finance is to keep flowing. With private-label securitisation markets moribund, and capital-strapped banks pulling in their horns, Fannie and Freddie are close to being the only game in town. This puts policymakers in a bind. They may want to shrink the firms’ vast portfolios, but where else can would-be homeowners get funding? Fears that Fannie and Freddie will write less business have contributed to a spike in mortgage interest rates recently.

The housing bill marks a big step away from the financial deregulation that has characterised the past 20-odd years. Whether it will do much to ease the crisis is less clear. House prices continue to fall precipitously: American homes remain overvalued compared with rents and household income, perhaps by 10%. Foreclosures continue to rise at an alarming rate. As the pain spreads, expect to see more of the state’s visible hand.