Fannie and Freddie: The Next President's First Migraine

It's time for McCain and Obama to speak up on the troubled mortgage giants.

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John McCain and Barack Obama have been choosing their words carefully when it comes to the foundering mortgage giants Fannie Mae and Freddie Mac. No doubt they're starting to realize that whoever gets elected in November is likely to get saddled with this massive problem on Day 1.

In July, when Treasury Secretary Hank Paulson secured the authority to bail out or even nationalize the two huge mortgage underwriters, the hope was that the government's explicit backing would be enough. If the government pledged to bail out the two agencies in an emergency, the theory went, that would reassure investors, who would keep buying Fannie and Freddie debt, since they wouldn't have to worry about a default. And the capital raised in the debt offerings was essential to keeping the two firms solvent so they would continue to buy mortgages and prevent the housing market from sliding even deeper into gloom.

But now it's looking like the government's word alone isn't going to cut it. A recent report in Barron's (subscription required) did the dire math and concluded that a government bailout, at taxpayer expense, is "increasingly likely," with most shareholders getting wiped out. Both agencies, which function like private companies, appear to be in a kind of death spiral, with mounting losses and plunging stock prices raising the specter of a Bear Stearns type of meltdown. So far, both companies are still able to issue debt to raise money. But their share prices are at record lows—and probably going lower.

If "market solutions" fail and the government gets directly involved, that will trigger a long workout period similar to a massive bankruptcy proceeding: The two companies, which underwrite half of all U.S. mortgages, would end up seriously reformed and maybe even extinct. That could transform the entire market for home mortgages.

The housing-bailout bill Congress passed in July gives the Treasury Department a blank check—basically, unlimited authority—to inject funds into Fannie and Freddie to keep them from collapsing. But that's a worst-case scenario everybody wants to avoid. The Bush administration is loath to bail out any firm in the first place, and for the CEOs of Fannie and Freddie, a government bailout would be colossal failure. Almost surely, they'd get sacked.

Everybody agrees, however, that Fannie and Freddie are too integral to the housing market, and the overall economy, to be allowed to fail. One thing that could trigger government intervention is a failed debt offering, which would signal that investors have lost confidence in the ability of the two firms to operate independently. Or Treasury could choose another moment to intervene.

If Barron's is right and a bailout is inevitable, here's the political calculus: If either firm faces a cash-flow problem or another crisis over the next three months, then the Bush administration will have no choice but to intervene prior to the November elections. So a bailout would already be underway once the next president takes office in November, leaving the new administration to figure out what to do with a Fannie and Freddie that are essentially in receivership.

If there isn't a crisis before November, the Bush administration could begin a more strategic bailout in the lame-duck days between November and January. But that seems unlikely: The last two months of an outgoing administration tend to be disorderly, with political appointees returning to the private sector and many key positions unfilled. Besides, why take on a nasty problem if you could leave it for the next guy to deal with?

And finally, the most intriguing scenario: Fannie and Freddie could limp along all the way through the elections into next year before succumbing—leaving it up to an Obama or McCain administration to conduct a bailout, without Hank Paulson, the mastermind of the blank-check strategy. And Obama and McCain have both been quite cagey about what they would do.

Obama has said practically nothing of substance on Fannie and Freddie. He opposes "a big bailout for shareholders and managers at the expense of American taxpayers," which voters no doubt will find a relief. But Obama has offered no details about what he thinks should happen to Fannie and Freddie. Former Treasury Secretary Lawrence Summers, an Obama economic adviser, has argued that the government should take over the two mortgage giants.

McCain has been more strident. As a senator, he backed legislation that would have reined in Fannie and Freddie during their heyday. And in July, after Congress passed the housing bill, McCain penned an op-ed in the St. Petersburg Times that was filled with moral indignation at the "crony capitalism" perpetrated by Fannie, Freddie, and their allies in Washington. McCain's remedy: "If a dime of taxpayer money ends up being directly invested, the management and the board should immediately be replaced, multimillion dollar salaries should be cut, and bonuses and other compensation should be eliminated. They should cease all lobbying activities and drop all payments to outside lobbyists. And taxpayers should be first in line for any repayments." That sort of setup sounds a lot like an ordinary government agency, not a quasi-private corporation.

No matter who gets elected, Fannie and Freddie are in a perilous spot: They're stumbling into the sights of politicians in an election year, with taxpayer blood on their hands. Surviving that may be even tougher than overcoming insolvency.