First, a little background:

Both Freddie and Fannie were initially created by the U.S. Congress with the goal of expanding the residential mortgage market. They are for this reason referred to as "government-sponsored enterprises", or GSEs, even though both eventually were converted into private companies for which there is today no explicit government guarantee of their debt....

After a homeowner has borrowed money to buy a home, the original lender likely resold that loan to Fannie or Freddie. The GSE in turn collected some of those mortgages in a pool which was sold in the form of mortgage-backed securities (MBS) to private investors, for which the GSEs collect a fee in exchange for guaranteeing payment on the MBS. Other mortgages purchased by the GSE are held directly by the GSE for its own investment portfolio. The GSEs obtained the funds for these investments primarily with money borrowed directly from private investors, which instruments are referred to as "agency debt".

The table below provides a simplified balance sheet for Freddie Mac. Most of the nearly $800 billion in assets held by Freddie as of the end of 2007 consisted of mortgage loans or securities based on mortgages. The company acquired the resources to buy these assets primarily by borrowing, with outstanding debt as of the end of 2007 of $738.6 billion. The key item on the liabilities side of the balance sheet is stockholders' equity, which represents the capital raised by Freddie through direct sales of stock and cumulative retained earnings. This equity provides a cushion against possible losses on any of its assets, in that the first $26.7 billion in losses would come out of the company's original capital, with creditors losing nothing. That cushion, however, would only cover losses that were less than 26.7/794.4 = 3.4% of the assets.

Fannie's 2007 stockholders' equity came to 5.0% of assets.

These balance sheets leave out the mortgage-backed securities that the enterprises created and sold directly to outside investors, for which the enterprises have issued off-balance-sheet guarantees for payment. The OFHEO 2008 Annual Report to Congress states that Freddie had sold $1,381.9 billion in MBS and Fannie $2,118.9 billion. If you add together the mortgages retained outright by Fannie and Freddie (either as whole loans or MBS) plus the MBS that they have sold to others and offer a guarantee for payment, the OFHEO calculates a total "book of business" for the two enterprises of $4,934.4 billion as of the end of 2007, slightly less than the total publicly held debt of the U.S. government. Fannie and Freddie's combined stockholders' equity amounts to 1.4% of their total book of business.

Fannie and Freddie borrowed the funds with which this empire was leveraged at terms nearly as favorable as those for the Treasury itself. Unquestionably a key reason that investors have received agency debt so warmly over the years, and treated the guarantees as credible, was the assumption that Fannie or Freddie were too big for the federal government to allow to fail. This creates an unambiguous concern of moral hazard. When investors assume that the government will cover their losses, the result is a higher volume of funds flowing into the GSEs than is socially desirable. The upside goes to the lender, the downside is supposedly picked up by the government, and the result is the enterprise is expanded to a greater level of risk than makes economic sense.

Source: Lockhart (2008).

The GSEs' book of business represented 25% of outstanding residential mortgage debt in 1990 but comes to 41.4% today. It is hard to avoid the conclusion that these moral hazard distortions were one factor that contributed to the rapid expansion of mortgage debt over the last decade and attendant excessive price appreciation and risk taking. Granted, the real excesses, such as the subprime loans that everybody was initially discussing, came from MBS created by private institutions rather than the GSEs. But the stock market seems to be declaring pretty loud and clear this week that risks associated with enterprise assets are significant.

Source: Yahoo Finance.

Source: Yahoo Finance.

So where do we go from here? If we indeed reach a point where one or both of the GSEs can no longer honor its commitments, the Treasury's contingency plan might follow the Bear Stearns philosophy of leaving shareholders nothing but protecting creditors and counterparties fully. But if the U.S. Treasury ends up assuming a significant burden, this would at a minimum raise the logistical question of how taxes are going to be raised to cover the costs. One strategy that holds some appeal would be to let the burden of the tax fall entirely on the creditors and counterparties themselves-- in other words, no government bailout at all-- as argued by Nouriel Roubini:

notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency-- as of now and in the worst scenario of $200 to $300 billion-- the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or-- for unchanged face value-- a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

So what's wrong with that idea? The overriding concern in dealing with the current mess is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. In addition, I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.

The principle of "make those who caused the problem pay" has a lot of visceral appeal. But the principle of "don't impose severe and gratuitous extra costs on those who had no role in causing the problem"-- in other words, don't make the housing depression much more severe just to teach somebody a lesson-- has to be the basis for our policy decisions.

My recommendation would therefore be for a managed bailout in which the stockholders, creditors and taxpayers jointly share the bill.

And now we can haggle about the price.

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