Centerblue.org

I honestly believe that if the average US voter understood the danger that Fannie Mae and Freddie Mac pose to our credit-hobbled economy there would be some serious blood on the streets in light of what’s going on with these two companies right now.

We face the specter of either an economic depression or financial insolvency if the worst fears about these companies come to pass. And sadly, some powerful Democrats have been asleep at the switch–because Republicans (and some Dems) are the ones that have rightly been setting off clarion calls on the threat posed by these companies for years.

Here’s basically how these companies work: Fannie and Freddie were chartered by Congress to help grease the wheels of the nation’s housing markets. Rather than force banks to extend mortgages and keep them on the books (which reduces available capital for creating new mortgages), Fannie and Freddie swoop in with borrowed money and either buy these loans or guarantee the banks against loss on them. They then repackage these mortgages into securities and sell them to investors, foreign governments, pension funds, and the like–and they are marketed as extremely safe investments.

Meanwhile, banks’ capital is freed up to make more mortgages, which the companies then buy up again, and so on. This easy mortgage availability played a big part in the housing bubble.

Fannie and Freddie make money because they are able to borrow at below-market rates, based on animplicit belief that, because the companies are government-chartered, the the government would step in to bail them out of any trouble. They use this cheap money to buy up mortgages and make a profit by repackaging them to investors at a premium.

In recent years, Fannie and Freddie lowered their lending standards right along with everyone else, so that even though their mortgages aren’t really the worst of subprime, nobody really knows just how much toxic waste has accumulated on these companies’ balance sheets.

These companies now own or guarantee almost half the nation’s mortgages. At the same time, they get away with razor-thin cushions of capital in case things go wrong–thanks to bare-knuckled lobbying of Congress. Rather than force these companies to rein in their business and more deeply cushion their rainy day fund, people like US Sen. Chuck Schumer continually blocked attempts to more thoroughly regulate their activities and basically gave them free rein to gamble with the nation’s economy.

Today these companies own $5.1 trillion in mortgages, and carry only $81 billion in capital to shield against losses. Now Wall Street and everyone who bought these “safe” mortgage securities is starting to get very, very nervous about what exactly these companies are holding. Their stocks fell by half their value last week alone.

Eager to head off another crisis, the Feds stepped in over the weekend–announcing plans to allow the companies to borrow undefined amounts of money from the Fed in the event of cash flow problems, and even saying the Treasury might buy up their stock (with taxpayer money) to shore up confidence. Of course nobody really knows right now just how bad the situation might be. If defaults continue to mount, the risk of failure by these two companies is very real in light of their thin financial cushions–and then the choices become very hard.

We could let the companies fail and all their securities become worthless, in which case we would face an economic depression. The mortgage market that has been supporting higher real estate prices for years would simply flip over and die. Lending would dry up radically as banks no longer have someone to whom they can sell even their best mortgages. Sharply reduced lending will exert severe downward pressure on housing prices as nobody is able to buy or sell, leading to even more foreclosures and distressed sales.

We could swoop in and put the companies into a conservatorship, essentially using taxpayer money to make good on their obligations. But if the bad loans equal in percentage terms anything near what the Bear Stearns of the world have suffered, then we’re looking at a bailout of hundreds of billions of dollars, or roughly equal to another Iraq war. I would argue the US Treasury can’t absorb such a huge cost–and would likely lead either to a wrecked credit rating for the United States with very serious financial consequences, downright insolvency, and/or both.

So–our government created two companies that are too big to fail, and too big not to fail, all in the name of pushing an “ownership society” and encouraging a spiral of housing prices. Now the bill has come due.

Economic depression or financial insolvency. Take your pick.