The mortgage giants are still caught in a negative spiral, even with backup from the Fed. By Fred W. Frailey, Editor July 14, 2008 The U.S. government has all but said it will do whatever it takes to prevent battered mortgage giants Fannie Mae and Freddy Mac from tipping into insolvency. Whether you think that’s a good idea or a foolish one, Washington really didn’t have a choice. It was step up or risk sending the nation’s housing market into chaos and gridlock. The question becomes whether the government will have to actually act on its promise to bail out these companies with your tax dollars. Here’s the plan hatched over the weekend: The Treasury will seek from Congress approval to strengthen a longstanding line of government credit to Freddie and Fanny (the present line of credit is relatively miniscule). Congress will also be asked to let the Treasury buy shares of stock in the two companies. The legislation would give the Federal Reserve Board a “consultive role” in deciding how much capital Fannie and Freddie should hold in reserve against mortgage loans that they own or guarantee going sour. Meanwhile, the Fed’s board of governors gave its blessing to lending the companies money “should such lending prove necessary.” In other words, so important are these two entities, which together own or guarantee more than $5 trillion of home mortgages, that the government has made an open-ended pledge to stand behind them come what may, although it hasn’t actually had to do anything yet. That promise should have quelled the flight of investors away from Fannie and Freddie. But on July 14, after an initial burst of enthusiasm over the plan on Wall Street—Fannie’s shares shot up 30% at the opening bell and Freddie’s 20%—they both resumed their downward spirals. Fannie traded at $40 at the close of 2007, and now just $9.73. During that same span of time, Freddie has fallen from $34 to $7.11. Advertisement You can only speculate why the promise of open-ended aid wasn’t enough to revive Wall Street’s confidence in these two government-sponsored (but shareholder-owned companies.) It could well be that investors believe that the government will indeed feel compelled to step in and use public money. Should that occur, it’s possible that the equity of existing shareholders would be wiped out. And doubts are compounded because even the biggest minds in finance have little idea where all of this is headed. Worse yet, Fannie and Freddie took the rest of the banking industry with them on July 14, as the selloff engulfed Citigroup (down 97 cents to $15.22), J.P. Morgan Chase (down $1.47 to $31.69), Bank of America (down $1.52 to $20.15) and Wachovia (down $1.70 to $9.84). The verdict on the rescue plan by economists was, at best, mixed. “This is a package designed to forestall a full rescue,” said Ian Shepherdson of High Frequency Economics. Chimed in Richard Yamarone of Argus Research: “Here we go again. We wonder where this process of injecting money into ailing industries will end. Will Lehman be the cause for another Sunday evening action?” And from Peter Wallison, the American Enterprise Institute economist who for years has called Fannie and Freddie ticking time bombs, came this warning: If the government bails out Fannie or Freddie without taking control of them in place of the present shareholders, the companies will just keep on taking the same risks that got them into trouble. Advertisement What the nation’s financial institution seems to be caught in is what the Wall Street Journal has called a “negative feedback loop.” An oversupply of homes led to steep drops in home values. Those steep drops caused foreclosures to balloon. And that, in turn, forced lenders declare losses. Those losses sapped the capital of the lenders, thereby shrinking the availability of money for new loans while also making those lenders suspicious of making them in the first place. Because it’s not clear when these waves of foreclosures will stop and let the financial system regain its equilibrium, a lack of confidence in that system spreads like a summer morning fog.