A report this morning indicated that the idea of formally taking over mortgage giants Fannie Mae and Freddie Mac (henceforth “FMs”) has crossed the minds of the president and his advisers. 

For the mortgage layman, an introduction to the mortgage process is in order.  It begins when a prospective mortgage borrower applies for a loan with a bank or mortgage broker.  A second party then underwrites the loan, seeking to answer the question: does the borrower’s ability to repay the debt indicate enough strength that another party would want to acquire the forthcoming income stream and assume the possibility that the debt may fail to be repaid?  Provided that the answer is a yes, the loan is approved and closed.  Generally, within 60 days the bank or broker sells the note to a third party investor, receiving the original principal balance of the loan in addition to a fee concession on forthcoming interest payments over the loan’s term.  This third party is almost always either of the FMs, who in turn maintains part of the packaged debt for them or sells their rights to additional parties.  The bond market perceives debt that is maintained by the FMs to be guaranteed by the US government. 

Due to dilemmas in the housing and credit markets, the FMs are presently in possession of debt instruments they perhaps wish were held elsewhere.   If, in fact, the worst-case scenario were to happen – that the FMs are now or soon become insolvent, and that the major guarantor of home mortgages in America were no longer a player – a number of effects would certainly be felt by the American macro-economy.  Banks would necessarily become more critical of borrowers’ applications, as they would actually assume firsthand risk for their decisions of credit-worthiness without the availability of a secondary market sale.  With an effective slashing in financing activity, the availability of potential homebuyers necessarily declines, and with it the market value of American real estate in general and American housing specifically.  Interest rates would be forced to increase, as the underlying financiers of a debt’s principal self-assume both repayment and interest rate risk.  Both of these effects, in turn, would further fuel the stagnation in housing.  Existing homeowners might find themselves upside down on their homes (that is, owing more than the property’s value).  Higher interest rates could potentially make new bond investors happy; further, a high interest rate environment induces savings.  In addition, though, a high interest rate environment will have two effects on stockholders of American companies: capital will be pulled by market investors from equities into bonds (as the higher rate climate raises a bond’s return), and American businesses will have a higher interest rate burden to raise capital, effectively slowing their intermediate-term growth potential.

As bad as this scenario sounds, it’s really nothing compared to the potential government takeover of the FMs.  I’ve written before about the effects of a monetary collapse of the dollar’s value.  At present, American M3 (the total amount of US dollars held in the world) stands at around $10 Trillion.  Bailing out the FMs at a price tag of $5 trillion will, necessarily, force 50% more US dollars into the world without any economic contribution in place to justify it.  This will inevitably and considerably devalue the US Dollar, perhaps by 50% or more.  I cannot fathom how this is in the public’s interest. 

Further, such a proposal is unequivocally unfair. Current bondholders who lent yesterday’s dollar of value would be repaid in tomorrow’s worthless dollar, destroying the integrity of an already fragile market.  Foreign investors in American real estate, who are not among the American taxpaying public, reap all the current benefit of their investment without the heightened public debt burden.  Government entanglement in the market is naturally effective as a neutral arbiter, and not as a picker of sides financed by the taxpayer (either through heightened taxes or the devaluing of dollar holdings).

 The government would, of course, dare consider a bailout of the FMs because Joe and Jane Q Homeowner are the very people who vote in November.  In campaigns decided by sound bites, the average voter wants to hear that they won’t be upside down on their home, not complicated dissertations on currency being devalued.  That it is not popular, though, does not mean that a hands-off policy isn’t best.  In fact, all of our knowledge as to how markets work shows us that a hands-off policy is best for all.