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Bailout Means Full
Faith And Credit
Terrell E. Arnold
As the US Congress wrangles over a bailout package while Treasury Secretary Paulson literally goes on his knees to pray for immediate action, just what the crisis is remains obscure to most people. There are two main questions: Just who needs to be bailed out, and what is the specific funding problem? Plunging boldly into the chill waters of investment banking and such arcane devices as mortgage backed securities, commercial mortgage backed securities and et cetera, the answers are not what you might expect. For better or worse, the US Government is now in the home mortgage business.
A home or commercial property mortgage, as such, is straightforward: A buyer (individual, family or company) selects a property that is for sale, determines what he/she/they have as a down payment, how much they can borrow, and what amortization schedule and interest rate they can handle, and if the seller plus funding source are happy, the deal is done. The mortgage backed security creator, whether the bundle is commercial, individual home, or other property based, takes a bundle of similar such done deals and turns them into a marketable investment security. Over the past several years an estimated 5-6 trillion dollars worth of these packages have been sold to investors, principally by Fannie Mae and Freddie Mac. Over a trillion dollars worth of those deals have been picked up by foreign investors, including mainly central banks. The big bundles are in China, Japan and Western Europe, but there are others.
Who did most of the bundling for these deals? While all eyes are on investment bankers, the bundles-upward of 80% at least-were put together by Fannie Mae and Freddie Mac. These bundles were then marketed by investment bankers, and with triple, that is AAA ratings, the bundles were attractive to central banks, mutual funds and others looking for remunerative and safe places for funds.
How do subprime mortgages get into this act? For the uninitiated, an AAA rated bundle of high risk mortgages sounds like an oxymoron. There are two levels to the answer: First, if you take a bundle of 10 such high risk mortgages the chances of the whole bundle going belly up are pretty slim. Bundling is a real risk mitigation device. That in itself, however, still would not seem to justify AAA ratings, because the risk of some failures-as has been demonstrated at the subprime level-is substantially greater than zero. Second though, as seen by the mortgage backed security buyer, the risk of failure was rendered minimal, because _Fannie Mae and Freddie Mac guaranteed payment of the interest and principal on all mortgages in the bundle, even if individual mortgage holders defaulted_. The AAA rating flowed from this guarantee, not from the intrinsic security of any mortgage bundle.
Given this guarantee, Fannie Mae and Freddie Mac got caught in the middle when the subprimes started failing. Worth noting is that reportedly in 2008 upward of 98% of payments on mortgages underwritten by them were current. They apparently had based their business model on an expectation that failure rates would be low to minimal, certainly manageable. (At least that is a reasonable explanation of their operation). In fact, as subprime mortgage holders started to fail, Fannie and Freddie were faced by rapid reduction in liquidity as a result of non-payments. They were not getting expected revenues, but they had guaranteed principal and interest returns on the mortgage backed securities they had sold. Although it involved only a small proportion of outstanding mortgages, the arithmetic was simply murderous, and the two were going belly up when the government stepped in. Everybody in the chain was undercut by the subprime failures. Nobody in the chain appears to have anticipated this debacle. In effect, virtually all of the banks involved were operating on thin reserve margins that simply did not allow for the order of subprime failures that occurred. The ones most deeply into the subprime market, e.g. Washington Mutual and Lehmann Brothers, along with Fannie Mae and Freddie Mac were caught flat footed.
One can say that since no one anticipated the subprime mortgage holder meltdown or the collapse in housing values that undercut even prime mortgage markets that ensued, no one is to blame. But who to blame is not the issue. Who to look to for making things right is the matter on the table. We are back to Fannie Mae and Freddie Mac. They hold, or guarantee more than $5 trillion in mortgages. But they are now in government hands.
Where then does responsibility lie? The Federal Housing Finance Agency (FHFA) has the authority and responsibility and placed Fannie Mae and Freddie Mac in conservatorship. According to Wikipedia, the effect of this action is that FHFA will "support the soundness of the obligations and guarantees on securities issued by Fannie Mae and Freddie Mac to obtain funds." That means essentially that the Fannie Mae and Freddie Mac guarantees of principal and interest payments on mortgage backed securities have become obligations of the federal government, read the American taxpayer.
Just like that, the United States Government is now, full time, in the home mortgage business as the intermediary between banks that make and sell mortgages and investment houses or others who buy, sell or hold mortgage backed securities. This makes the alleged bailout not a bailout at all but funding to support a suddenly assumed Federal budgetary responsibility to maintain the liquidity of Fannie Mae and Freddie Mac, and to preserve their reputations in financial markets.
This is a critical action as foreign investors, especially the big holders of mortgage backed securities, may see it. In recent news reports, Japan and China, both big time holders of these securities, have indicated satisfaction with the takeover decision. Others who hold parts of the more than trillion dollar overseas component of the US mortgage backed securities market should also be pleased.
If it can be carried out successfully, the "bailout" will serve to minimize or avoid both further foreign and domestic losses. However, the President, Secretary Paulson and Fed Chairman Bernanke should be stressing the obvious argument: The takeover of Fannie Mae and Freddie Mac by the Federal Housing Finance Agency and the commitment of FHFA to support their guarantees and obligations puts the full faith and credit of the United States on the line. How this plays out will affect American business and financial relations both at home and with the rest of the world for years to come.
The writer is a retired Senior Foreign Service Officer of the US Department of State. He served in key economic interest countries such as Egypt, India, the Philippines and Brazil. He has an MA in political science and economics from San Jose State University, he is a graduate of the National War College, and he studied development economics at the University of California, Berkeley. He will welcome comments at wecanstopit@charter.net
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