Wednesday, September 10, 2008

Fannie and Freddie's Bailout Disaster

We just received the following note from a correspondent. If you are genuinely concerned about the situation faced by so many of America's homeowners, you might want to forward this posting to individuals you think would be interested and want to know what to do about this crisis.
"Given that the Government just seized control of Fannie Mae and Freddie Mac, and given that their combined outstanding bad debt is $1.5 Trillion, and that the government wishes to reduce this to $250 Billion a piece. . . And given that the engine of the American economy has been home ownership for the last half century. . . I'd be curious as to your thoughts on how the economy will fare based on existing paradigms."
To this we'd have to respond that we think the government is making a colossal mistake in taking ownership of two enterprises that could and should be privately owned and subject to the same market forces as any industry. Secretary Paulson and his Wall Street friends are trying to change the rules of a free enterprise system to "socialize the risks" made by speculators, all in the name of "democratic capitalism" on a scale not seen since the New Deal.

We believe that the government should own nothing that can be managed and operated competitively in the private sector. All enterprises should be subject to market disciplines, especially where many workers and citizens could become owners with incentives to operate at maximum efficiency, reduced costs, and solid bottom-line results. It is not in the nature of government, a natural monopoly, to operate efficiently. We hope that more Americans won't have to suffer too much more before demanding real change: the Just Third Way and Capital Homesteading for every American.

Assuming the numbers you supplied are correct, a reorganized Freddie and Fannie would still be left with $500 billion in unsound mortgage paper, against their existing presumably sound $3.5 trillion mortgage portfolios. The $1 trillion balance in bad loans would be written off at the expense of investors, banks, mortgage syndicators, hedge funds, and sovereign loan funds that supplied the credit, presumably knowing that they should have added an appropriate risk premium based on the home buyers' vetted ability to service the debt.

The problem is, what is to become of the people whose mortgages are written off? A trillion dollars, even at inflated prices, represents a lot of homes. If media reports are correct, Fannie and Freddie own half the outstanding mortgages in the United States, and this writes off 20% of those. Again, if your figures are correct, then a full tenth — 10% — of all outstanding mortgages in the United States will be written off, and presumably foreclosed, a disaster of unprecedented proportions for real, ordinary people, not faceless investors, banks, mortgage syndicators, hedge funds, and sovereign loan funds.

The question becomes, what is to be done with these loans?

Our solution is to arrange for legislation to enable competing Homeowners Equity Corporations (HECs) to purchase the homes with mortgages in default at the deflated prices (or to take over the mortgages at a discounted price, as described in our "HEC Paper." Credit for acquiring the homes or discounted mortgages on a 100% leveraged basis would be supplied to the HECs from local banks that are members of the Federal Reserve, and the HEC's loan paper would be discountable at the regional Fed.

People living in the homes would become renters, and their rental payments would pay off the HEC's loans. HEC shares would be allocated to the renters' HEC accounts, equal in value to the amount the HEC borrows to acquire the house or discounted mortgage. When the rents on a specific home service all interest and principal due on the HEC's mortgage for that home, the renter's shares would be repaid in full, giving the occupant the right to transfer his shares for direct title over the home from the HEC, or keep the shares and pay a significantly lower rent, sufficient to cover taxes and maintenance. The more homes a HEC acquires, the more there is a spreading of the risk of default on the HEC's overall credit exposure. Such pooling of risk would be the equivalent of private home mortgage insurance.

With respect to the assets (sound home mortgage paper) remaining in Fannie and Freddie, the two companies should have been required to file for a Chapter 11 reorganization. This would force a restructuring of each company's management and financial structure, so that each company could become operational again with the reduced assets. They would, however, now operate so that each would have to compete in the future with other companies, with the understanding that there would be no further guarantee of taxpayer support for their losses. Previously outstanding preferred and common stock would be radically reduced in market value or even eliminated in the reorganization process. Whatever shares remain outstanding could be purchased by the ESOP trust of the new S-Corporation that would emerge from the Chapter 11 proceeding, also on a 100% leveraged basis repayable with untaxed future profits generated by the new worker-owned Fannie and Freddie.

For HEC renters who could not afford to pay HEC rentals (and maintenance fees), housing vouchers from Federal and State governments would have to be made available to supplement incomes from other sources.

Surely this is better than burdening the U.S. taxpayer with a potential financial meltdown of another $4 trillion, as well as throwing 10% of mortgage holders out in the street.

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