CEPR Statement on the Bailout of Fannie Mae and Freddie Mac July 16, 2008 The collapse of the housing bubble has put the survival of Fannie Mae and Freddie Mac in jeopardy, as those of us who warned of the bubble have long predicted. While there can be no question of supporting these mortgage giants at such a critical moment for the housing market, the public should place serious conditions on this support. These companies face bankruptcy because of the incompetence of their management. They should not be given unlimited access to taxpayer dollars without any strings attached. Before delving into the terms and conditions of the bailout, it is important to be clear on why Fannie Mae and Freddie Mac are in crisis. Last week's downturn may be attributable to a sudden change in sentiments in financial markets, but the underlying problem is not investor confidence. The underlying problem is that Fannie and Freddie either own or guarantee a large number of mortgages that are in default or will be in default in the very near future. This is due to the collapse of the housing bubble. In ordinary times, the prime mortgages that fill the bulk of Fannie and Freddie's portfolios go bad at very low rates. And when they do default, most of the debt is covered, since the value of the house is typically close to the value of the mortgage. The collapse of the housing bubble, however, has created extraordinary circumstances where even prime mortgages are going bad at very high rates. As many mortgages in former bubble markets sink further underwater, Fannie and Freddie now own or guarantee mortgages on homes that will lose in the neighborhood of 50 percent of their value. Fannie and Freddie both contributed to the bubble and created the financial crisis that they now face. These mortgage giants continued to make loans in bubble-inflated markets, thereby supporting purchases at bubble-inflated prices. Their top economists insisted that there was no bubble, assuring others in the market that everything was fine. If Fannie and Freddie had constrained their loans, and tied their price to multiples of rent (e.g., a maximum loan value of 15 times appraised annual market rent for an area), they could have done much to stem the growth of the housing bubble and protected themselves from the bankruptcy they now face. As mortgage insurers go under, Fannie and Freddie will have to bear the full loss on many of these foreclosures. These losses will swamp their reserves and will force them into bankruptcy in the absence of government support. The run on Fannie and Freddie's stock is due to the fact that investors finally recognized the inevitability of this state of affairs. With Fannie and Freddie now supporting almost 70 percent of new mortgages, it is essential that they stay in operation. However, it is reasonable to insist on stringent conditions for taxpayer support. First, the managers who were too incompetent to recognize the largest housing bubble in the history of the world should be replaced. The public should not be asked to pay six, seven, and even eight figure salaries for people who cannot do their jobs. Second, compensation should be sharply limited, topping out in the neighborhood of $2 million annually. Compensation in the financial sector has exploded with no obvious gain in performance. The bailout of Fannie and Freddie and other financial institutions provides an opportunity to rein in outlandish pay. Most economists recognize the growth in wage inequality over the last three decades as a serious problem. The federal government should not make this problem worse by effectively subsidizing the salaries of some of the highest paid managers in the country. Third, to ensure that public funds are used to stabilize distressed markets, rather than slow the deflation of bubble markets, Fannie and Freddie should be required to limit their mortgages to a reasonable multiple of market rent for an area. As home prices inflated, rent never grew out of line with market fundamentals. By adopting rent-based appraisals of market value, Fannie and Freddie can ensure that their loans reflect a house's value, regardless of whether it is in a bubble market or not. Finally, in the wake of the bailout, Fannie and Freddie could be put into a receivership arrangement and run as fully public companies. Whether they are restored as partially private companies can be debated by Congress while the two companies are restored to solvency. The failure of the economists and managers at these institutions to recognize the housing bubble earlier has proven enormously costly to the United States and the world economy. The conditions of any bailout should protect the public from further losses by holding management accountable for their irresponsibility, reining in executive pay and creating reasonable standards for future lending. ---------- <http://salsa.democracyinaction.org/dia/track.jsp?v=2&c=hsO0CL%2FIhePj9d1ZrVYenhGpc3SEJUib>Dean Baker is the co-director of the <http://salsa.democracyinaction.org/dia/track.jsp?v=2&c=pBl04CWBbXAOY1voiCFP8RGpc3SEJUib>Center for Economic and Policy Research (CEPR). He is the author of "The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer" (www.conservativenannystate.org). His blog, "<http://salsa.democracyinaction.org/dia/track.jsp?v=2&c=eDQpgIIu3X5jNsNYCi7wgBGpc3SEJUib>Beat the Press," discusses the media's coverage of economic issues. ---------- The Center for Economic and Policy Research is an independent, nonpartisan think tank that was established to promote democratic debate on the most important economic and social issues that affect people's lives. CEPR's Advisory Board of Economists includes Nobel Laureate economists Robert Solow and Joseph Stiglitz; Richard Freeman, Professor of Economics at Harvard University; and Eileen Appelbaum, Professor and Director of the Center for Women and Work at Rutgers University.
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