The joint announcement by the US Treasury and the Federal Housing Finance Agency of the placement of Fannie Mae and Freddie Mac into conservatorship represents a decent first step aimed at shoring up market uncertainty and injecting an element of stability into domestic financial markets in the short term. In particular, utilization of recently granted legislative authority to purchase mortgage-backed securities through the end of 2009 and the construction of the Government Sponsored Enterprise Credit Facility under the guidance of the US Treasury should provide significant boost to market confidence over the coming days.
In particular, given that the plan permits the Treasury to hold the securities through to maturity, the spreads between Treasury issuances and the government sponsored enterprises mortgage backed securities imply that there is a chance of taxpayers loses from the program. Should market conditions improve, in fact, the program could produce gains.
However, the short-term nature of the plan remains problematic and there is a risk that uncertainty over the extent to which the plan is adequate to address the significant problems in the market remains outstanding.
First, the plan addresses the issue of liquidity but not solvency. We think that the surge in defaults among sub-prime, alt-a and prime homeowners caused by the economic slowdown will likely to provide a continued challenge to the capital base of both Fannie and Freddie. While the promise of possible public gains from the program is a fine talking point, is it realistic to expect that market conditions will improve to the extent in the near term to obtain that end?
Second, the very large mission that the Treasury and FHFA have just undertaken looks to have added at least $100 billion of debt onto the books of the Federal Government, with the likelihood of much more that will have to be added in the out years. This is inherently inflationary. The combined efforts of the credit facilities at the Federal Reserve and the novel one set up at the Treasury today will require a further increase of the money supply that is not consistent with the notion of price stability.
Third, the size and scope of the problem is so large that the Treasury under the current legislative mandate cannot solve it. While, Mr. Paulson’s statement does strongly suggest that policymakers should view the interstitial between today and December 31 as a “time out” we are not certain that under the current conditions that our public actors recognize the severity of the issues at hand.
In and of itself, the admission by the Treasury of the “time out” is signal that this plan is not a solution but temporary levee constructed to avoid the much greater flood that will occur if far greater action is not taken in the interim.
While we recognize the logic of purchasing time until a new administration and Congress has time to settle in. We think that the severity of the crisis demands further action in a timely manner that may not be consistent with waiting until the legislative authority expires at the end of 2009. The short-term utility function of getting re-elected on the part of our political actors does not outweigh the greater responsibility to the commonweal.
Since the beginning of the crises at Fannie and Freddie we have made the case that the firms needed to be nationalized with the intent of privatizing them in an orderly fashion over the next decade. The short term steps taken today may provide some material comfort to markets in the coming days, but contrary to the statement issued today it does not provide medium to long term clarity for the markets.
