Fannie Mae & Freddie Mac – a bigger role for Treasury?

Fed’s semiannual monetary policy testimony to the Senate Banking Committee concluded that the economy still faces difficulties in the form of financial strains, declining home prices, a softening labour market and high and rising commodity prices. The Fed also knows the negative real Fed fund rate is inconsistent with its long-run low inflation objective, but weak economic conditions and credit stresses prevent it from hiking rates anytime soon. The Japanese economy so far is probably not in recession, but is getting closer to one. Business investment growth is slowing on deteriorating profitability and sentiment. As a result, trading thinned out by vacations and volatility driven by rumours and aggressive chatter from analysts and commentators.

To bolster confidence, the Fed Reserve and US Treasury Department announced that it will allow the Fannie Mae and Feddie Mac to borrow from the discount window at the primary credit rate ‘should such lending prove necessary’. Borrowing would be collateralized by US government and federal agency securities.

The Fed noted that the move is intended to supplement the Treasury’s existing lending authority. For once, market concluded that is the bondholders, not shareholders, who will be supported and sparked a flight from equities into bonds. Many still think that the two Government-sponsored Enterprises (GSEs) will have to be nationalized, hence increases the fiscal burden on the federal government and hurt the US dollar. Freddie Mac is also reported scheduled to sell US$3 billion in short term notes today.

The problems with the GSEs are pretty straightforward. Both GSEs need more capital and perhaps far more than their current market capitalization. Combined, they have about US$95 billion capital and hold over US$5 trillion in mortgages. Former St Louis Fed Reserve President William Poole asserted that these institutions are essentially on a short path to insolvency. And make no mistake. The problems with them have to be resolved as they are doing 80% of the mortgages in the US. Without them, the housing market would grind to a halt quickly and housing prices would drop even beyond Gary Shilling’s pessimistic views. Not to mention that the world has assumed the implicit backing of the government in buying the paper of Freddie and Fannie.

If the access to the Fed’s discount window failed to resolve the issue, then the Treasury appears to be laying the ground work to take a temporary equity stake in the two enterprises. Higher mortgage rates are the last thing the housing market and the broader economy need today, which ultimately make these problems all that much more difficult to solve. They are too tightly wound into the core and fiber of the US economy. Otherwise, the authorities are slowly losing control.