Fannie, Freddie Bailout Should Be Good for the Market

I love the government rescue of Fannie Mae (FNM) and Freddie Mac (FRE). We'll look back on it in a little while and realize it was the turning point in the credit crisis and the housing downturn.

Still, I concede that in many ways it's a government rip-off. And it sets terrible precedents for the power of government to intervene in the private economy, and to expropriate private property in the process. Perhaps that's why the market hasn't responded better to it.

First let's look at the enormous good that has been accomplished here.

Fannie and Freddie are critical elements in the United States mortgage market. With so much of that market already damaged or taken out of action by the collapse of subprime lending, it was absolutely critical that Fannie and Freddie keep functioning. If they had stopped functioning, mortgages would have become virtually unobtainable, and home prices would fall far further because no one could finance a home purchase.

That scenario is off the table. The Treasury Department, by announcing it will buy mortgage-backed securities issued by Fannie and Freddie, has made itself the mortgage lender of last resort.

Just as important, the Treasury has taken off the table any risk of default in the trillions of dollars worth of mortgage-backed securities issued by Fannie and Freddie in the past -- which represent about half of all mortgages outstanding. These securities are guaranteed by Fannie and Freddie in terms of timely payment of interest and principle, and millions of individuals and institutions around the world have always relied on that guarantee. Now that guarantee is good beyond doubt -- which should go a long way to arresting the cycle of fear sweeping the credit markets.

Even before the takeover, for the Treasury to fail to stand behind that guarantee would have been an unthinkably horrible mistake. Technically, that guarantee was made by two privately owned corporations -- Fannie and Freddie -- not the U.S. Treasury. So Treasury could have just stepped aside. But Fannie and Freddie are "government sponsored enterprises," too. So failing to honor that guarantee would have been tantamount to a default on the sovereign debt of the United States.

You think the credit crisis is bad now? Believe me, you wouldn't want to live in a world where that had happened.

The rescue is already beginning to work. Mortgage rates have fallen sharply, making housing more affordable. And the value of subprime and Alt-A mortgages has risen, taking pressure off the banks and brokers with too-large legacy positions in them.

So as The Joker would say in the new Batman movie, "Why so serious?" Why has the market not reacted more joyfully to the Treasury's rescue of Fannie and Freddie? Why does it seem that the news just keeps getting worse and worse?

The main reason is psychology. The Treasury's rescue signals to the market that things are truly terrible -- otherwise, the Treasury wouldn't have taken such a radical step. So suddenly there is another revaluation of the risks at other troubled financial firms, such as Lehman Brothers (LEH) and Washington Mutual (WM).

And perhaps the rescue of Fannie and Freddie comes too late. That's not to say it won't help -- it will, and a lot. But it would have helped even more if it had been done a month earlier. Or for that matter, six months earlier. Damage has been done to the financial system, and even though the Treasury rescue will be an effective cure in the long run, we are still suffering from that damage and it will take time to be repaired.

But there's another problem with the rescue, too. If government can step in and "take over" two companies like Fannie and Freddie -- and wipe out the value of investments in them by existing shareholders in the process -- then couldn't the same thing happen at other companies?

It happened at Bear Stearns, didn't it? The government didn't take over Bear directly, but a large government loan made J.P. Morgan's (JPM) takeover possible.

So who's next? The thinking may be, why should I own stock in any bank or broker when on some fine Sunday night the government may decide to expropriate my investment for the sake of the greater good, and pay me nothing?

Last Friday, before the Fannie and Freddie takeover by the Treasury was announced, those companies were worth about $11 billion. Now? Nada. Without warning. Without so much a specific trigger event that made it a real emergency. Sure, supposedly the Treasury's investigative team supposedly found accounting irregularities and concluded that Fannie and Freddie were weaker than they looked on paper. But nothing was discovered that hadn't already been known by any analyst on Wall Street for months.

It seems that the Treasury just got scared and arbitrarily decided to do it -- just because. Or maybe it's because there's an election coming up, and the administration wanted to be seen as "doing something." But whatever the reason, why shouldn't the Treasury have to pay for what it takes?

Isn't that what the Fifth Amendment of the Constitution of the United States guarantees? That when government takes private property for public use it must pay "just compensation"? If I were a Fannie or Freddie shareholder, I'd be calling my lawyer -- and getting ready to take this one all the way to the Supreme Court.

The bottom line is that the takeover of Fannie and Freddie objectively does a lot of good for the housing market and the credit market. It takes huge risks off the table, and sets the preconditions for sustainable recovery.

But that's an intermediate-term effect. In the near term, it's raised issues about the value of owning financial stocks. If Fannie and Freddie are worth zero, then why not Lehman Brothers, too?

My guess is that this new panic will blow over fairly quickly, and by the time a week has passed investors will be more focused on the prospect for long-term recovery now that Fannie and Freddie have been stabilized. That makes this a buying opportunity.