On September 7, 2008, Bush Treasury Secretary seized Fannie Mae and Freddie Mac (the GSEs). At the time, the GSEs backed $5.4 trillion in mortgage loans, or one half of the total residential mortgage market. Up until that date, the GSEs benefited from an implicit guarantee. After government seizure, the guarantee became explicit.
Yesterday, in its report downgrading the US, S&P cited their earlier report projecting total losses to the government approaching $700 billion from the assumption of the GSE's liabilities. Others suggest a worst case scenario of $1 trillion. As of August 2010, total losses reached $226 billion and the government had injected $148 billion in capital. Since then losses continue to mount with the announcement yesterday that Fannie increased its loss reserves for mortgage losses to $75 billion. So by any measure, the bailout of the GSEs constituted an enormous expense incurred by the last administration that greatly contributed to our debt problem and the S&P downgrade yesterday.
The Fannie and Freddie bailouts have been termed "the mother of all bailouts." This seems apt due to both the huge amount of money at stake in the ultimate unwinding of the GSEs as well as the centrality of Fannie and Freddie to the US financial system. Mortgage backed securities issued by the GSEs constitute 29% of the taxable bond market in the US, nearly as much as Treasuries. Currently, the spread between Treasuries and GSE securities are near record lows as illustrated by this graph:
This graph shows that the market currently believes that GSE paper is about as safe as Treasury obligations. It also shows that the bailout was an unadulterated giveaway to holders of GSE obligations. More specifically, to the extent the spreads have compressed over time due to the more explicit government guarantees, holders achieve a windfall in the form of higher bond prices for their holdings arising from the more explicit guarantee. None of this windfall went to debtors on the underlying mortgage backed securities (MBS), as they continued to be obligated at stated interest rates on notes entered into prior to the more explicit guarantee. In other words, 100 percent of the government's expenditures to make good on the MBS guaranteed by the GSEs went to wealthy holders of the MBS (bond investors, banks, and foreign governments like China) on September 7, 2008, and none of it benefited the home owners obligated on those debt obligations. Thus, we bailed out bondholders and banks and rich investors, not homeowners on September 7, 2008.
After the bailout homeowners benefited from lower mortgage rates, but this benefit may not last much longer. The Housing and Economic Recovery Act of 2008 granted the Treasury the authority to provide the GSEs with unlimited capital (by purchasing their stock) in order to maintain their solvency, and Treasury exercised this power to cover losses through 2012 (plus $200 billion each). After that, unless Congress acts, the GSEs are on their own. Their fate will be in the hands of this current Congress--the very Congress that just triggered an S&P downgrade based on "political brinkmanship." As managing director of S&P John Chambers stated: "The political gridlock in Washington leads us to conclude that policymakers don't have the ability to put the public finances of the U.S. on a sustainable footing." The GOP arson squad lacks sufficient political maturity to deal with the GSEs in a responsible way.
Therefore, it would be hard to imagine that the GSEs would maintain their credit ratings much longer. And, unlike Treasury debt, the market for GSE paper could see a disorderly unwinding as investors who currently believe they hold bonds nearly as safe as Treasuries are in fact subject to the whims of the current Congress. That could spell trouble for the financial markets, bank capital, the residential real estate market and the economy generally.