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Sunday, September 07, 2008

McCain on the Fannie / Freddie Bailout

On the September 7, 2008 edition of Face the Nation, Senator John McCain made the following comment about the forthcoming Treasury intervention at Fannie Mae and Freddie Mac (loosely paraphrased):

I’ve talked with Treasury Secretary Paulson and the deal is structured so that when housing recovers, and it will, the American taxpayer will be the first to be paid off.

This indicates a lack of understanding of how the securitization process works. When a retail loan is sold by the originating lender, the originating lender gets their money in its entirety and they no longer have any exposure to a default from the borrower. When Fannie or Freddie buy that loan and manage to resell it to yet another party, they too no longer have any exposure to a loss if the borrower defaults. The risk lies only with those mortgages Fannie and Freddie have “in inventory” awaiting resell or those they choose to keep in their portfolio.

The impact is easier to follow with a specific example. Start with a mortgage issued for a home originally sold in 2006 in California for $500,000 with a $450,000 mortgage (10 percent down) with interest-only balloon terms increasing the payments in 2008. Assume the loan itself was resold to Fannie or Freddie between 2006 and 2008 and is still sitting in their “inventory” and now the borrower has defaulted on the loan and cannot make the higher payments. Also assume the house itself is now worth only $400,000, below the mortgage amount. In this example at the time of the default:

* the original lender is “whole” and lost no money and WILL lose no money
* the borrower cannot afford the house unless terms are renegotiated by the current note holder (Fannie or Freddie)
* the current loss on the mortgage is $50,000 (difference between the note and current home value) since the interest-only note paid down no principle
* if the house is sold to another party, THAT party cannot be forced to borrow from Fannie or Freddie to help them make up their losses on the current borrower

The key point is that once a loss on a loan is recognized, that loss hits the books of Fannie or Freddie. A future mortgage on the home involved with that loss is originated at the retail level to the new borrower – Fannie and Freddie are not retail lenders. If that mortgage isn’t resold to Fannie or Freddie, then future profits from that subsequent mortgage won’t flow to Fannie or Freddie. As a result, any restructuring plan for Fannie and Freddie cannot “guarantee” taxpayers that future profits when prices recover will make up interim losses suffered absorbing current defaults. If Fannie and Freddie cannot more accurately reflect the provenance of mortgages they are reselling to identify those in geographic markets that are underwater or at higher risk for default, investors will simply shun ALL of their MBS offerings, further tanking the market. If they adequately disclose the quality of loans within their MBS offerings, investors will simply shun those tied to the riskiest markets, sticking Fannie and Freddie with the junk, keeping the losses isolated to Fannie and Freddie and, hence, US taxpayers.

If the bailout plan for Fannie and Freddie simply involves providing Treasury backup for the solvency of the entities’ books, then there is NO WAY the plan can allow US taxpayers to be made whole in the long term as the market recovers. The losses will stick with the entities (and taxpayers) and the profits from mortgages to future borrowers will flow to the final note holders. Such a plan would only serve to hopefully keep the problem from getting worse via further liquidity problems but will do NOTHING to eliminate losses absorbed by taxpayers. If the bailout plan requires Fannie and Freddie to surrender all profits back to the government until losses are repaid, they will have a very difficult time reorganizing themselves and attracting new outside capital, further deepening their dependency on taxpayers. If the bailout for Fannie and Freddie allows the new government conservators to waive the rules of accounting and NOT mark the value of defaulted mortgages to market and defer recognition of the losses, we have a much more critical legal and financial problem.

None of the solutions for the problem are attractive and none are likely to protect us from a further meltdown without protecting many guilty parties in the financial industry and allowing them to keep the profits from this colossal fraud. However, it’s disconcerting to see a reform-minded Presidential candidate claiming the deal will (eventually) make taxpayers whole and confirming a critical lack of understanding about the basics of a trillion dollar problem he would inherit if elected.