Will Fannie and Freddie fail?

The so-called Government Sponsored Enterprises, Fannie Mae and Freddie Mac, together with the Federal Home Loan Bank, have played a central role in shoring up the housing-finance market since the sub-prime meltdown began. It is not much of an exaggeration to say that they have become the entire market. But the more money they have pumped into housing, the faster their own financial condition has deteriorated. Now investors are ditching Fannie and Freddie stocks; on Thursday shares in Freddie fell nearly 20 per cent, to their lowest since 1991. Anxiety had been building for a while, then worsened suddenly when Bill Poole, a former head of the St Louis Fed, said that Freddie was technically insolvent in the first quarter under mark-to-market accounting (that is, the value of its assets was less than the value of its liabilities).

It is inconceivable that the government would stand aside and let these institutions go down: to say that they are too big to fail hardly does the case justice. Their liabilities are now larger than those of the entire federal government. If regulatory forbearance--the traditional approach to the GSEs--should fail, and the choice comes to standing by or outright nationalization, it would be the latter in a heartbeat. The question is not whether there would be a bail-out, but how hard the terms would be on creditors and shareholders. (Bear Stearns was not allowed to fail--but its shareholders were crucified.) We may very well discover the value of that fabled "implicit guarantee". Owners and lenders alike are having second thoughts about it: shareholders are running for the door and lenders have raised their spreads sharply.

Will a recovering housing market come to the GSEs' rescue? Not for some while yet. Consider what Janet Yellen, boss of the San Francisco Fed, told the UCSD Economics Roundtable this week (via Econbrowser):

Unfortunately, it appears to me that there are at least three reasons for thinking that housing prices have further to fall. First, the ratio of house prices to rents—a kind of price-dividend ratio for housing—still remains quite high by historical standards, despite having fallen from its historical peak reached in early 2006. That suggests that further price declines may be needed to bring housing markets into balance. Second, inventories of unsold homes remain at elevated levels. This "excess supply" of available homes will put downward pressure on housing prices. Indeed, these inventories are likely to directly depress construction activity, since there is little point in building new homes when there is already a large backlog of unsold homes. Third, the futures market for house prices predicts further declines in a number of metropolitan areas this year. In particular, the Case-Shiller composite index for home prices shows a 15 to 20 percent year-over-year decline in the second half of this year. The bottom line is that construction spending and house prices seem likely to continue to fall well into 2009.

In short, the GSEs' financial condition is going to get worse before it gets better. If it happens, a rescue of Fannie and Freddie would dwarf not only anything seen up to now, but anything even contemplated. This crisis isn't over.