The Fannie Mae & Freddie Mac Takeover

 

“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.” – Treasury Secretary Henry Paulson, Jr.    

Last night’s Charlie Rose TV show had a panel discussion of the Federal Government’s takeover of U.S. mortgage giants, Fannie Mae and Freddie Mac. The panel included Nouriel Roubini of New York University, Mohamed El-Erian, co-CEO of PIMCO and Gretchen Morgenson and Floyd Norris, both of The New York Times. (I faithfully record the Charlie Rose show every night, knowing that, most of the time, he will have an enlightening, or at least interesting, program. Tonight, he will have Thomas Friedman, who will discuss his new book.)

Nouriel Roubini was, as expected, the most pessimistic about the future direction of the economy. He has been called, among other things, “Dr. Doom,” but the truth is that he has been prescient about the various crises we have seen. It is his belief that, because the government “subsidized” home ownership, we invested too much in housing, instead of more productive assets.

Things are so bad, Roubini said that “we have a subprime financial system, not a subprime mortgage market.” This has led to a systemic banking crisis.

Roubini listed various simultaneous shocks to the U.S. economy:

• Consumers are “shopped” out
• Housing prices are falling and will continue to fall
• Stock prices have fallen
• Consumers are facing a large debt burden
• Banks are less willing to lend
• Consumers are dealing with rising oil and food prices

Roubini thinks that this is an unusual, if not unprecedented, confluence of events, as bad as we have seen since the Great Depression. He believes that the U.S. recession will get much worse and will last for 12 to 18 months, and that there is the strong possibility of a global recession and a “vicious circle.” He does not go so far, though, as to predict another Great Depression.

And to top things off, he commented that “Superpowers” should not be net debtors. Observing the huge and still growing U.S. deficit, Roubini said this could be indicative of the beginning of the decline of the “American Empire.” Whew! Heavy stuff.

Mohamed El-Erian’s analysis was somber, but not nearly as scary. He believes that the credit crunch had “morphed” into an economic crisis, which is in desperate need of crisis management. He sees the takeover of Fannie Mae and Freddie Mac as necessary, and as a bold attempt to change the “regime.” (Paradigm?) He believes that, in the next two years, the government will go from crisis management to an evaluation of the situation and, finally, to crisis prevention. He believes that a major reform effort will be required by 2010.

Speaking of reform, Gretchen Morgenson expressed her extreme disappointment at the failure of policy makers and regulators to address the problem earlier. Whether it was the SEC, the Federal Reserve Board, the U.S. Treasury or the bank regulators, she feels that there was a wholesale failure to recognize the problem. “Denial, upon denial, upon denial that there was a problem,” was how she described it. As a result, she sees a lack of credibility in the administration.

Morgenson commented that there was enough blame to go around, meaning banks, mortgage brokers, and consumers, in addition to the government, were at fault.

El-Erian “defended (!)” the regulators by saying that they knew that there was a problem, but they just didn’t know what the solution was, and they didn’t want to make things worse.

Somehow, this does not make me feel more confident.

Norris said that the takeover was necessary, to prevent the crisis from getting worse. He agreed with Roubini that the danger is a “negative loop,” where things just keep getting worse. He feels that we must do a much better job of regulation, especially in the “alternative financial system,” that has largely been unregulated. Norris was the only one to mention the fact that former Federal Reserve Bank Chairman, Alan Greenspan, was strongly against regulating financial markets, because he did not want to stifle innovation.

Norris highlighted the failure of top management of banks, who did not control risk. They may have thought they were making tons of money, but they weren’t, because they relied too heavily on models for reassurance that they were not taking on too much risk.

My interpretation is that they just did not think that we could have a nation-wide decline in housing prices. Bank management thought that the packaging of risky loans reduced the overall risk, through diversification. But, this could not be true if the underlying loans were extremely dicey, and in some instances, simply fraudulent. Everyone assumed that housing prices could go in only one direction – up — or if prices declined, it would be mild and temporary.

Take Home Message

One fear is that, if people are “underwater” or “upside down” with regard to their home mortgage (that is, their house is worth less than the outstanding balance of the mortgage) they will just walk away, leaving the bank to deal with a foreclosure and possibly a forced sale of the house. This is what the government is trying to avoid, or at least diminish the likelihood of it. It will not be an easy problem to solve. Roubini made the startling prediction that, of the people who have mortgages on their homes (and not everyone does, by the way), 40% will be “underwater.”

On the plus side, these recent actions by the Federal Government seem to have strengthened the confidence of foreign investors in the U.S. markets. El-Erian says that international investors view the U.S. markets favorably, because we have the deepest market in terms of liquidity, and we adhere to the rule of law. People living in the United States may take this for granted, but it is something to consider.

I would add that our dynamic, entrepreneurial “can-do” spirit is a huge advantage globally, so I am not quite ready to count the U.S. out, yet. We do have serious problems to address but, though long overdue, the Federal Government,seems, at last, to be on the case.

Postscript

For a fascinating portrait of Roubini, see this New York Times article.  In September of 2006, he was extremely pessimistic about the banking system, housing prices and the economy, and was mocked for his predictions. However, his critics dismiss his correct call because they point out that he was pessimistic about the economy back in 2004, as well. Read the article and judge for yourself whether it was “the broken clock being right twice a day” syndrome.