donsutherland1

Last November (http://www.debatepolitics.com/econom...tml#post680195 (The Subprime Mortgage Crisis: Some Thoughts)), I noted that should the federal government raise Fannie Mae's and Freddie Mac's loan limits to permit them to invest in jumbo mortgages that the odds of taxpayer dollars being required to address the increased financial costs associated with investments in those non-corforming mortgages would be high. Since then, legislation was adopted that empowered those two government-sponsored enterprises (GSEs) to purchase jumbo mortgages. Now, the risk of at least a partial taxpayer bailout aimed at helping them maintain a reasonable capital cushion has increased.

On July 10, Bloomberg.com reported:

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

"Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole, 71, who left the Fed in March, said in an interview.

Separately, a report issued by S&P indicated that a bailout, if it became necessary, would have the potential to cost taxpayers more than $1 trillion.

In my view, Fannie Mae and Freddie Mac should continue to increase their capital. At the same time, they should be engaged in capital conservation efforts, meaning that they would make no dividend payments and would avoid purchasing any non-conforming mortgages even as they have statutory authority to do so. At a time when home prices continue to decline, even as the rate of descent has been slowing over the past two months, overleverage should be discouraged. Hence, both GSEs should avoid purchasing jumbo mortgages, particularly when their capital cushion is so thin and their cost of capital is increasing.

The failure of one or both of these entities, which is not yet the most likely scenario, would have the potential to pose systemic financial system risk. The two GSEs should be focused on mitigating the probability of a scenario in which taxpayer financing becomes necessary.

donsutherland1

For purposes of highlighting what I believe were some flawed decisions that contributed to the need for the federal government to take both Fannie Mae and Freddie Mac into conservatorship, I noted the following news story back in November in this thread (http://www.debatepolitics.com/econom...l#post680195):

I also suggested:

...the Bernanke proposal would put added pressure on an entity that is already experiencing a decline in profits. Hence, odds of taxpayer dollars being required to address the increased financial costs associated with Fannie Mae's investing in non-conforming jumbo mortgages would be high. In sum, the Bernanke proposal does not make much economic sense...

The economic stimulus legislation President Bush signed into law in February, increased the $417,000 limit on conforming mortgages that could be purchased by Fannie Mae and Freddie Mac by 75%. Both GSEs were permitted to purchase mortgages of up to $729,750 through 2008 when that authorization expired. Congress could extend such authorization.

I was worried then that undercapitalized institutions would not be well-served by making larger mortgage purchases. Although the full details as to how many such larger mortgages were purchased have been made publicly available, such mortgages were purchased and those purchases almost certainly increased pressures on the undercapitalized GSEs. Hence, I am not suprised that the situation reached its dramatic conclusion last weekend. It remains to be seen just how significant the adverse impact of the temporary authorization for purchases of non-conforming mortgages will be.

The main principle at hand is that firms facing liquidity challenges should take measures to conserve capital. That means slashing/eliminating dividends and other unnecessary expenditures. An approach that actually increased cash outflows was bound to be detrimental. That approach probably did not drive both GSEs into conservatorship, as they were in a slow-motion deterioration before such authorization was granted. However, it did contribute toward that end and probably accelerated that outcome. It likely has made the challenges associated with recovery a little more difficult than they would otherwise have been.