• D.C. Current

Treasury's Backstop Blues

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BOTH PRESIDENTIAL CANDIDATES VOW TO END Fannie Mae and Freddie Mac as we know them.

This can't happen soon enough. Despite the new government-appointed masters at the companies, taxpayers still are getting the short end every time the entities issue a new bond. This is because the bonds are sold to investors at a higher yield than Treasuries of similar duration, even though now there is no risk of default.

You would expect the bonds to trade at parity with Treasuries, or close to it. Yet when Fannie Mae sold $7 billion in bonds last week it had to offer a yield that was 70 basis points higher than yields on comparable Treasuries. And as of last Wednesday, five-year Fannie Mae bonds still traded at a 65-basis-point premium.

"Isn't that a windfall?" asks James Barth, a senior fellow at the Milken Institute in Santa Monica, Calif. Barth said it would be far less expensive to taxpayers if Treasury sold its own securities to finance the two mortgage entities.

Of course, Treasury would need an act of Congress to do this, so don't hold your breath. Massachusetts Rep. Barney Frank's Financial Services Committee will hold hearings on the Treasury takeover of the two congressionally chartered, stockholder-owned institutions later this month. There's no plan for Congress to enact any legislation before year's end. In fact, lawmakers largely are ignorant of the windfall problem.

Fannie Mae was created by Congress in 1938 in the Great Depression to help people buy homes. It purchases mortgages from lenders who in turn use the proceeds of the sale to make even more loans. Fannie then takes the mortgages and bundles them into securities and sells them to big investors like mutual funds, pensions, and even foreign governments. Originally, Fannie Mae bought only FHA (Federal Housing Administration) loans, partially guaranteed federal loans designed for buyers of modest homes.

Freddie Mac was created in 1970, at the behest of the savings-and-loan industry, to buy non-FHA loans. Eventually, Fannie Mae was also allowed to purchase other types of mortgages. Prior to the government takeover, both companies were shareholder-owned. But their debt and securities had the implicit backing of the federal government because the corporations were congressionally chartered.

Democratic standard-bearer Barack Obama and GOP contender John McCain both state that the federal government's role in the mortgage market must radically change.

"We cannot continue with a privatize profits/socialize losses structure going forward," says Austan Goolsbee, an adviser to Obama. He adds, however, that this doesn't preclude a public-sector role for creating a mortgage market.

McCain sees the Fannie/Freddie problems as the result of crony capitalism, little transparency, and the implied backing of the taxpayer. "Sen. McCain will get real regulation that limits their ability to borrow, shrinks their size until they no longer are a threat to our economy, and eliminates their links to the government," says McCain adviser Doug Holtz-Eakin.

Treasury did not guarantee Freddie and Fannie bonds when it seized control of the two entities -- the largest takeover in history. Treasury doesn't have the power to guarantee the bonds, says department spokeswoman Michele Davis. All that it did do was promise both entities would have a positive net worth, in effect ruling out any bond defaults stemming from a lack of capital.

Stewart Taylor, an Eaton Vance senior fixed-income trader, doubts the mortgage-company debt ever will trade at parity. First, he says, there is uncertainty about the future of the two companies. He also notes that while bonds issued by the Tennessee Valley Administration are pretty stable -- the AAA-rated securities have first claim on the proceeds of power sales -- they nevertheless trade at a significant discount to Treasuries.

Rob Shapiro, an economist for the NAN, a progressive Democratic think tank, points out in his blog that in the wake of the government's assumption of $5.2 trillion in Freddie-Fannie debt, Treasuries may no longer be perceived as good as gold. "A modest but significant share of that is headed for default, and the Treasury will have to absorb the losses," he writes. "And the result is a rising price for credit-default swaps on the U.S. government: It now costs $18,000 to insure $10 million of U.S. Treasury debt. The market sees a very small but not negligible prospect that the government would default on its debt -- which would be, well, the end of the American and global economies as we know them. That's how bad it is."

Another reason for bond-investor uncertainty is that Congress might repeat its past mistakes by over-promoting home ownership in the future, compounding the mess. The Milken Institute's Barth studied housing data from the first quarter of 1965 to the second quarter of this year and discovered that housing markets are stable when home-ownership rates hover between 64% and 67% but unstable either above or below that band. The rate now is 68.1%, down from a high of 69.2% in the second quarter of 2004.

Congress should reconsider buying votes by promising everyone a house. Having a third of our households in rental units might not be so bad after all.