Why the Fannie/Freddie Bailout Seems Cheap

How much will it cost the beleaguered taxpayer?

That's one of the big unknowns in the housing bill signed by President Bush, which among other things gives the Treasury a blank check for bailing out Fannie Mae and Freddie Mac. The explicit backing of the U.S. government might be enough to help the two mortgage giants sort out their own problems. Or, they might need billions in loans or stock purchases. Whatever the cost, it will ultimately come out of taxpayers' pockets.

But what if there were no bailout? Would taxpayers be off the hook? Not by a long shot.

The ideological arguments over whether a bailout is appropriate regard the "American taxpayer" as a shopper buying a product he doesn't really need: He can spend the money and get some benefit, or he keep the money for himself and enjoy the status quo.

But that's not how it works. Many taxpayers are homeowners, too, and if "taxpayers" weren't standing by with the cash for a bailout, then "homeowners" and everybody dependent upon them would pay a steep price of their own. It's hard to put numbers on it, but the cost of rescuing Fannie and Freddie is probably a lot less than the cost of doing nothing. Here's why:

The health of Fannie and Freddie directly affects home values. For the housing market to recover, buyers need to materialize and start purchasing a huge inventory of unsold homes. To do that, they need loans, which Fannie and Freddie support, by buying or guaranteeing nearly half of all mortgages issued in the United States. This is the famous "liquidity" that lubricates the housing market. If Fannie's and Freddie's problems forced them to cut back on the number of loans they were able to back, liquidity would dry up: Banks would lend only to the safest borrowers, and fewer people would qualify. Instead of putting 10 percent down, for instance, imagine rules that required buyers to put 30 or 40 percent down. Or prove that their monthly mortgage payment would be a small fraction of their total income.

There's plenty of research showing that the value of homes is directly related to liquidity: If lots of people can afford homes and get loans, then demand rises, and so do prices. But if there are few buyers—the situation now—values sag. "The cost of credit and the availability of credit are the key to housing prices," says Susan Wachter, professor of real estate and finance at the Wharton School. "If young buyers can't buy, then you can't sell."

Home prices have already fallen about 15 percent from their peak, and most analysts think they probably need to fall 10 percent more or so before the market bottoms out. If a Fannie/Freddie meltdown caused a lending crisis, home prices would fall further still, making the overall economy that much worse for the ordinary taxpayer.

It's the wrong time for market solutions. Fannie and Freddie could tough it out in the market, without government help, but that would cause deep problems before it solved anything. With a plunging stock price and questions of insolvency, they'd both probably have to sell some of their best assets—such as securities backed by healthy loans. That too could cause a lending crisis, because it would effectively flood the financial markets with mortgage-backed securities, lowering their value. Demand for fresh mortgages would fall, leading banks, once again, to raise standards and issue fewer mortgages. With fewer people able to qualify, demand for homes would fall, along with prices.

Down the road, when Fannie and Freddie are on firmer ground, the government will probably re-evaluate their hybrid public-private status. Former Federal Reserve Board member William Poole has argued, for example, that private firms should gradually take over the role Fannie and Freddie play in the housing market. But for now, a big Band-Aid is probably the safest treatment. "What's being done makes the most sense at the current time," says Jim Barth, an economist at the Milken Institute and a former banking regulator. "A market-oriented solution might have worked several years ago, but not now, in an emergency situation."

The bailout could end up costing very little. We'll know over the next few weeks whether the federal backstop alone will help Fannie and Freddie raise enough capital to get out of the danger zone, by issuing new debt or equity, for instance. There's good reason to think that it will: With the feds ready to step in, debt issued by either of the firms is theoretically as safe as treasury securities, a huge reassurance to investors. That alone might allow the firms to raise all the money they need in the regular financial markets, without having to ask Treasury or the Fed for help. If that's the outcome, then the bailout will turn out to be a great bargain: It will help restore stability to the housing market with nothing more than congressional ink and a few stern words from top financial regulators.

That will leave a lot of other problems. Why should Fannie and Freddie executives get huge salaries and bonuses, for instance, if they're really no different from public servants like the treasury secretary or the chairman of the Fed (annual salary for each: $191,300)? Why should the two entities enjoy a competitive advantage—the low borrowing costs associated with debt backed by the U.S. government—over private firms that do basically the same thing but enjoy no such guarantee? And why should Fannie and Freddie employ armies of lobbyists if they're basically government agencies? Good questions all. Let's deal with them when we get this little housing problem taken care of.