Taxpayers Bear Brunt of This Bailout

Fannie Mae and Freddie Mac helped lower interest rates in the more than 30 years since the introduction of mortgage-based securities, but taxpayers will be left holding the bag for their current bailout plan.
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Since the creation of the mortgage-backed securities market in the 1970s,

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

have allowed homeowners to secure lower mortgage rates.

All the benefits from the past thirty plus years, however, will likely be washed away by the

federal bailout

of the two firms now on the table, which critics say will eventually leave taxpayers holding the bill.

It's difficult to say exactly how much homeowners have saved on lower mortgage rates from having Fannie and Freddie around.

The two government-sponsored entities, which collectively own or guarantee about $5 trillion in U.S. residential mortgages, receive tax breaks and have lower costs of capital. This allows them to purchase mortgage loans and mortgage-backed securities at lower yields.

In turn, banks and mortgage lenders can offer lower interest rates on mortgages to homebuyers, knowing they can sell the loans to Fannie and Freddie.

Fannie's and Freddie's lower cost of capital results from Wall Street's perception of an implicit guarantee that the federal government will back up the two firm's debt if they ever face insolvency -- as some argue is happening today.

Thus, in effect, the federal government provides a subsidy to both firms, with the presumption that the subsidy will be passed on to homebuyers in the form of lower mortgage rates.

David Reiss, a professor at Brooklyn Law School who thinks both Fannie and Freddie should have been privatized a long time ago, says any eventual bailout will result in an income transfer from taxpayers to homeowners -- who were the ones benefiting from lower mortgage rates.

"Some people will say, `We had 30 years of better mortgage rates from Fannie and Freddie, so maybe this bailout is worth it,'" Reiss says. "But it is much better to design a stable financial system where there is not the possibility of a big blowup down the line."

If the bailout eventually amounts to $300 billion, as some have estimated, people will be hard-pressed to say it was a good deal for taxpayers, Reiss says.

The best estimate of the savings Fannie and Freddie have provided to homeowners over the years probably comes from a report from the Federal Deposit Insurance Corp. in 2004. It said the companies' guarantees on mortgage-backed securities cut about 40 basis points off the instruments' yields. Assuming most of this spread goes back to homeowners in the form of lower mortgage rates, then homeowners have surely benefited since the 1970s.

Based on last week's average 30-year mortgage rate of 6.37%, then presumably homeowners would pay 6.77% for the same mortgage if Fannie and Freddie weren't around, using the FDIC math.

However, testimony from the Congressional Budget Office in 2001 pointed out that not all the federal subsidies flow directly to mortgage borrowers, since shareholders in Fannie and Freddie grab some of the profits from the increased competitive advantage the two firms get from the subsidies. (Essentially, it's impossible to compete with Fannie and Freddie, since they have such low costs of capital).

The problem now is that Fannie and Freddie need more money. Both firms have gone from subsidizing the mortgage market to now being explicitly subsidized by the federal government. Treasury is extending increased lines of credit to the firms, while also pledging possible equity investments. Who pays for that? The U.S. taxpayer.

Estimates on the ultimate price of a publicly-financed bailout are staggering.

Nouriel Roubini, professor of economics and international business at New York University, estimates that Fannie and Freddie collectively face a capital shortfall of $200 billion to $300 billion, which is the amount by which he says their liabilities exceed the fair values of their assets.

Such a cost is similar to the amount paid by the U.S. government to save the savings and loan industry in the 1980s.

"We have subsidized through Fannie and Freddie, the most wasteful and unproductive form of capital ever," Roubini says. "We have too many homes and not enough machines."

Roubini thinks the two firms' bondholders should eat this cost, not U.S. taxpayers. That's because bondholders have been compensated by about a 100-basis points spread above Treasuries for buying Fannie and Freddie debt, he says. At the same time, if the government bails out Fannie and Freddie, then bondholders don't experience a credit loss. Instead, they've been directly subsidized by the federal government.

Based on the $5 trillion in liabilities between the two firms, that amounts to a $50 billion annual subsidy today to "Wall Street, the investors, and the well-connected," Roubini says.

If bondholders collectively took a 5% haircut on the value of their Fannie and Freddie loans, this could fund the $200 million to $300 million shortfall in capital at Fannie and Freddie, he says.

However, he admits this plan is unlikely, partly due to the large clout by Wall Street firms who are whining for a bailout. He calls the Treasury plan "socialism for the rich."

The popular phrase getting thrown around by many critics is that the entire history of Fannie and Freddie will prove to be a classic example of "the privatization of profits and the socialism of loss."

But the added malfeasance is that if you were a renter and didn't buy into bubble home prices over the past five years, then you're now being overly penalized.