Tuesday, September 9, 2008

Uncle Sam Saves Fannie and Freddie

The US Treasury Secretary Henry Paulson announced the weekend seizure of Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). While some have criticized the US regulators' handling of the mortgage crisis, there is almost unanimous agreement that the bailout of the two mortgage giants was absolutely necessary to prevent a major, worldwide financial markets collapse. The cost of this bailout to the US taxpayers is estimated to be at least $200b.

Who are Fannie and Freddie? Both are government sponsored enterprises (GSEs) that guarantee or own more than $5 trillion of mortgages, about 50% of all the mortgages in the United States. Both have suffered heavy losses in the ongoing real estate bust in the United States. Home prices have been falling and many homeowners have lost most or all of their equity in their homes. In many cases, the outstanding mortgage balance is greater than the reduced value of the homes. There have been many mortgage defaults and rising number of foreclosures. The major banks and financial institutions in the US and Europe have had to mark down or write off hundreds of billions of dollars worth of the US mortgage-backed securities. What started as a sub-prime crisis of problem loans obtained the less credit-worthy has now spread to the entire market. Even though the interest rates are fairly low, the banks are unwilling to lend even to the individuals and institutions with good credit. Fannie's and Freddie's ability to raise funds in the bond market has been severely impacted because of concerns about their viability. The latest action by US government is to restore confidence in both organizations to help revive the housing market.

But why are they so important to the US and the world economy? To understand the answer, let us look at the role the US government has played in creating a large middle class and a highly productive economy that is still considered the engine of the world economic growth.

During the second world war, the US economy was essentially geared to mass production of military hardware to support the war effort. Consumer economy was starved of the resources and rationing of essential items was widespread. As the war ended and a large number US soldiers (GIs) started to return, the US Congress passed the GI bill which paid for their free education. At the same time, the US government used Federal Housing Administration (FHA) and Fannie Mae to offer home loans on easy terms to help the GIs purchase their first homes and start their families. With the availability of skilled labor and consumer demand from new homeowners, the US industry transformed itself from military production to consumer production to create a consumer boom.

Ever since the 1940s, the US policy makers have considered home ownership a cornerstone of US policy. Not only have the successive US governments supported the funds availability for home loans with the addition of Freddie Mac in 1970, but they have also continued tax deductibility of mortgage interest to promote home ownership. Growth in home ownership has helped Americans build equity, increased their net worth, and stimulated consumer demand to drive economic growth. Housing has become so important to the US economy that the monthly housing data is eagerly awaited by the policy makers, businesses and markets as a leading economic indicator.

In spite the recent mortgage problems and the current housing crisis, the US policy of promoting home ownership has been a great success. Along with the implementation of GI bill and various student loan programs, these policies have significantly expanded the US middle class and the US economy and created tremendous employment opportunities.

The strong US consumption has turned the US economy into the engine of worldwide growth and a major export market for countries in Europe and Asia. The recent explosive growth of emerging economies such as China and the Asian tigers would not have been possible without the insatiable consumer demand in the United States for their products.

Taking a leaf from the US housing policy to stimulate Pakistani economy, former Prime Minister Shaukat Aziz encouraged borrowing by introducing low-rate mortgages in 2003. This initiative led to a construction boom and expanded housing for the growing middle class in Pakistan, contributing significantly to new jobs creation and rapid GDP growth.

In terms of Bhutto's Pakistan People's Party's promise of roti, kapra aur makan (food, clothing and housing), Fannie and Freddie have been largely responsible for makan (housing) in the richest and most powerful economy of the world that produces more than a quarter of the world's GDP. A genuine emphasis on makan (housing) and education by US policy makers has created lots of jobs and helped produce or buy a lot of roti and kapra (food and clothing) as well as electronics, TV sets, computers, cars, and other consumer goods and services.

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