Fannie-Freddie Bailout From the Top Down

I believe that most investors will ultimately recognize that the announced solution to Fannie Mae's (FNM Quote) and Freddie Mac's (FRE Quote) problems was already built into market prices, as evidenced by the recent performance of both the common and preferred shares of the two companies as well as the recent compression of credit spreads for agency debt. In recent days, it was also obvious from the way investors were grumbling about being held in limbo on the GSE issue that something had to happen soon. The most prescient call on this front was the now-famous virtual pounding on the table on television last week by Bill Gross at Pimco, whose clear and concise voice was a clarion call and warning to Hank Paulson to put the finishing touches on the capital-fortifying plan and announce the Treasury's takeover of the GSEs.

The Treasury's solution is unlikely to be viewed as a cure-all for the housing problem -- the elimination of the excess supply of unsold homes is the cure -- but it is one of many things that had to happen in order to fix the housing problem. This means that there will be continued low valuation of mortgage collateral, bank failures and general angst in the financial sector, at least until home prices bottom, which I again emphasize depends upon the inventory picture. The Fannie/Freddie solution merely enables the liquidation process to continue; it will not hasten the process.

Consumer sentiment probably won't be buoyed much by the bailout because the bailout in itself is unsettling and complicated, which will overwhelm any sense that the bailout will keep the drops dripping from the spigot for the financing of mortgages. In the end, people care most about the value of their own homes, anyway.

I think it good that the GSEs are being allowed to expand their portfolios (to $1.7 trillion from $1.5 trillion) before shrinking them (to $500 billion), which will keep money flowing into the housing market and help bring inventories and hence prices into a more stable condition. There is risk, however, in the timeline, as the new rules call for the GSEs to begin shrinking their portfolios by 10% per year beginning in 2010, which will likely be well before the inventory situation has been materially improved. Fingers will be crossed in hopes for a meaningful drop in home inventories by the end of 2009, or at least an extension of time before the GSEs are shrunk. Thank goodness progress has begun on this front, at least in the new home category, and prices are now more consistent with incomes and rents.