What Will The Candidates Really Do?

The Treasury Secretary of the United States took over Fannie Mae and Freddie Mac over the weekend. Last week, Pimco, a huge bond dealer, refused to buy anymore of the short term paper of either agency. Privately, both the Russian and Chinese Government buyers had also called the Treasury. Secretary Paulson already had decided that both institutions were too big to fail, that these two institutions going under would do extensive damage to the capital markets here and throughout the world.

There are thousands of questions that remain, starting at Treasury itself. By taking over these two institutions, the implied government guarantee is now explicit. This means that you the American taxpayer, if you are an American taxpayer, are essentially guaranteeing the mortgage pools issued by these institutions, even those stinky subprime loans. Wayne Angel, a former Fed Governor, said that they would need deeper capital reserves in the future. One estimate is a minimum of $200 billion.

The capital markets rejoiced today. Credit speads narrowed (take the yield of the Freddie Mac 10 year bond and divide it by the Trasury 10 year yield. As the spread narrows, things are getting better; as it widens, things are getting worse). Bank stocks soared. Fannie and Freddie both dropped to $1 per share since their stockholders will lose everything.

The average person gets almost nothing from this. Mortgages will get cheaper, but the price of houses won't necessarily stop dropping. You need more qualified buyers, and the banks aren't going to make it easier to get a mortgage. The people who are underwater because the price of their house is now below their mortgage will still be underwater. The people who are being foreclosed will still be foreclosed.

Earlier today, Senator Jim Bunning, Republican of Kentucky called the Treasury's move Communism, the state takeover of the Housing Industry, in essence. I'd have thought it was Socialism, but I'm not a U.S. Senator.

To see how the individual makes out, you must take a long term view, and understand the original mission of both Freddie Mac and Fannie Mae and why they were created. I will try in very short order.

Originally, special banks called savings and loans paid higher savings rates to savers to get capital, and they made mortgages to people to buy houses. They held the mortgages until people paid them off. The average life of a mortgage was 6 years and 10 months. In that time, in a self-amortizing mortgage (you paid a little principal and mostly interest so after 30 years you actually paid off the mortgage) you paid mostly interest and then paid the bank back the principal. You might be refinancing to get some cash out, you might be moving, but you typically refinanced.

The bank had to maintain a reserve to service the depositors, who might want to make a withdrawal now and then. The reserve proves to be a limit on what a bank can lend. There is also a reserve for losses, assuming that some loans will go bad, the underlying real estate secured, and then sold to reacquire the capital. Works fne except when the value of the real estate drops.

Now, what if there wasn't enough money in the savings and loan system to finance the number of people who wanted houses? With the modern miracle of computers, you can create an underwriting matrix, or in plain English, a computer system that runs 80 tests or so on a mortgage application, including income ratios and expense ratios, if you have a telephone, etc. And then the computer can buy the mortgage from the savings and loan offering it.

The computer could buy tens of thousands of conforming loans, loans that conformed to the rules that the institution established that buy mortgages. The S&Ls wanted the deal, they get a 1% servicing fee for collecting the monthly payment on the mortgage, plus they got the discounted present value of the mortgage (dig that fancy finance lingo, it means what the mortgage is worth today).

The institution then forms a pool of mortgages that is geographically distributed, etc. The pool will yield an average reflecting mortgage risk in the country. Shares are sold on the pool to institutional investors. As long as there is a spread of 16 basis points (0.16%), the institution will make money. The process is called securitization, the institution could be either one of the companies, since putting more money into individuals hands to buy homes was the goal. Ultimately, it still is. It's just hard to see.