Monday, December 28, 2009

A Holiday Gift from The Treasury

By Scott Tolep

On Christmas Eve, the US Treasury announced that it would provide unlimited capital over the next three years, if necessary, to cover losses suffered by mortgage agencies Fannie Mae and Freddie Mac (previously the limit was set at $200 billion each). The obvious initial reaction here is that the Treasury is issuing a “blank check” to the mortgage agencies and is jeopardizing the future direction and size of the ever-growing public debt. However, there are four compelling reasons to believe that the Treasury’s decision will not increase the public debt and will support the continued stabilization of the housing market and economy:

(1) After December 31, 2009, The Treasury will discontinue its purchases of MBS, which have totaled around $200 billion since the onset of the housing crisis and have kept mortgage rates at historical lows (The Fed has a separate MBS purchase program, set to expire at the end of first quarter 2010, and is expected to reach $1.25 trillion). The Treasury’s and Fed’s purchases have undoubtedly played key roles in keeping mortgage rates low and dramatically improving the housing market. As of October, unsold inventory of both new and existing homes were at their lowest levels in 3 years or more. It appears that the worst of the housing crisis is over, so it is likely that the agencies have already received the bulk of Treasury capital infusions they'll need (~$110 billion).

(2) Psychology plays an important factor in all markets, and the housing market is no exception. Yes, housing and the economy are stabilizing, but this painful cycle is still fresh in the minds (and bank accounts) of investors and lenders. The US will continue to experience periodic setbacks on the heels of this housing-led recession. With the Treasury discontinuing its MBS purchases, market participants are more likely to overreact to these setbacks, with the potential for destabilizing the housing market and economy and sending them back into a tailspin. The Treasury's decision to provide unlimited capital guarantees to the agencies over the next 3 years mitigates this risk.

(3) The Treasury has gained significant credibility after recovering a large percentage of the TARP funds it had injected into the banking system. It was announced earlier this month that $185 of the $245 billion that TARP invested in banks (75% of total) is scheduled to be returned to taxpayers with a profit.

(4) The Treasury’s decision should not lead to a loss of market discipline or create a “too-big-to-fail” attitude within the Agencies, as they are both currently under government control and underwriting standards are much tougher than they were in the 2005-2007 era.

Of all the US bailout investments, Freddie and Fannie may be the two most important because housing is what drove this recession and it also makes up roughly 30% of the average household net worth. The Treasury’s Christmas Eve announcement was a welcoming holiday gift not only for Fannie and Freddie, but also for the entire US economy.

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