On Friday, July 11, the nation’s two largest housing government-sponsored enterprises (GSE), Fannie Mae and Freddie Mac, began a precipitous stock slide that stirred a mini-panic on Wall Street and among government officials.  There was a frantic bid to craft a government rescue plan over the weekend.  On Monday, federal officials rushed to the nearest open microphone to reassure the nation that these mortgage behemoths were in no real danger of going belly up. 

The crisis in confidence over the GSEs was triggered by investors’ concerns that a significant percentage of the GSEs’ mortgage-backed securities could be losing value and that the GSEs, which by law are allowed to hold a much thinner cushions of cash than commercial banks, may not be able to handle the losses. 

The details of the federal plan are still being hammered out, but the dramatic fall in GSE value has finally illuminated, once and for all, the key underlying issue related to Fannie Mae and Freddie Mac:  the so-called implicit government guarantee that has always shadowed these entities, causing innumerable market uncertainties and policy quandaries, has now become painfully explicit.  The taxpayers are, in fact, being forced to backstop them, whether they want to or not.  Surprise, surprise.

Under current law, the U.S. Treasury has the authority to throw open the lending window to the GSEs so they can access their legally allowable $2.25 billion lines of credit.  Past that, however, the administration will have to involve Congress to enact other special provisions.  The plan calls for an 18-month temporary increase in the limits on those lines of credit.  The most controversial portion of the plan would temporarily permit the federal government to buy equity in the two GSEs should they need infusions of cash, although it is unclear how much the government would be allowed to buy and the terms and conditions that would govern those transactions. 

The Treasury is also asking that the Federal Reserve be given permission to perform a consultative role in any adjustments of the GSEs’ capital standards.  These maneuvers would insinuate the federal government further into the mortgage markets than it has ever been.  The consequences of this unprecedented intrusion are still unclear, but taxpayers can bet they won’t be good.    

The GSEs carry $5.2 trillion in mortgage debt and they either own or guarantee more than 70 percent of the nation’s home mortgages.  If the taxpayers were compelled to assume the entire debt (which is considered very unlikely), it would increase the current $9.2 trillion national debt by more than 50 percent.    

The proposal initially encountered choppy legislative waters.  The House and Senate have both passed housing bailout bills.  Treasury Secretary Henry Paulson, House Financial Services Committee Chairman Barney Frank (D-Mass.), and Senate Banking Committee Chairman Chris Dodd (D-Conn.) are grappling with the details of the GSE rescue plan and have telegraphed their intention to graft this new GSE bailout proposal onto an already controversial housing bill.    

Meanwhile, House Republicans have called for more time to review the ramifications of the proposal, since it heralds long-term implications for the financial and housing markets for years to come.  They may try to slow it down and hold hearings on it. 

Both versions of the housing bill currently call for the enactment of a new GSE regulatory regime but also contain several unpalatable provisions, including an extraneous affordable housing fund which would siphon off a portion of the GSEs’ profits into a slush fund to distribute grants to achieve vaguely-defined affordable housing goals.  Before the stock slide, it was estimated that the fund could have reached $1 billion annually.  Both bills call for a permanent increase in the size of mortgages the GSEs are permitted to buy, a highly questionable provision in light if their recent stock deflation as well as their impenetrable accounting tendencies. 

Long-time GSE allies on the Hill, who view the GSE debacle and the administration’s desire to attach the rescue plan to a now nearly-completed housing package as a fresh opportunity to add on other spending features, are putting pressure on Chairman Frank to resurrect an earlier proposal, opposed by President Bush, for a new $3.9 billion in grants to states and localities in order to help them purchase foreclosed properties.

Consider the dramatic change in the administration’s attitude toward the GSEs since September 2007.  At that time, Secretary Paulson testified that “If we knew then what we know now, we likely would not have designed entities like the GSEs that have private ownership but are required to undertake a public mission.  These competing interests are too difficult to manage, and the potential long-term market distortions and public policy concerns are too significant.”

Without delay, Congress must impose structural changes on both GSEs in order to get a bead on the full extent of their operational issues.  Serious thought must be given to the idea of seeking the legal authority to dramatically downsize and restructure Fannie Mae and Freddie Mac and eventually breaking them up into smaller, fully privatized concerns.  There would be up-front taxpayer costs associated with this concept, but those costs are smaller than the undefined financial abyss of providing the GSEs with an open-ended, no-strings attached bailout currently under consideration.