In support of the new housing law, Treasury Secretary Henry Paulson asked Congress for a blank check to fund any obligations that quasi-private mortgage giants Fannie Mae and Freddie Mac might face in an emergency.  This struck some in Congress as fraught with the perils of a taxpayer bailout. 

A blank check? Yes, said Paulson. That way the Treasury’s commitment (combined with Fannie and Freddie access to new loans from the Federal Reserve System) would not actually have to be used. The proposal would do for the mortgage giants what the creation of FDIC deposit insurance did in 1933 to prevent runs on commercial banks. Then as now, if everyone knows you are backed by “the full faith and credit” of the U.S. government, then everyone can calm down and get on with the mission.

Paulson’s proposal underlined the fact that neither Fannie nor Freddie was yet backed by the full faith and credit of the U.S. government. Instead, they occupied an ambiguous perch as private, for-profit corporations that had a special relationship to the government, one marked by an implicit guarantee of government support in a crunch.

Fannie and Freddie are private companies that originated as “government-sponsored-enterprises” or GSEs.  These hybrid entities have been chartered by Congress to help serve a policy goal, such as making credit more available to a certain sector in the economy. The first example was the Farm Credit System, created in 1916. As the table shows, GSE rescues are not unprecedented.

Fannie Mae, the Federal National Mortgage Association, was created by Congress in 1938 to promote the availability of mortgage credit for homebuyers.  In 1968, President Lyndon Johnson wanted to move FNMA’s substantial debt off the books of the federal government, so FNMA was privatized. Since then, its capital has come from its stock issues, and its stockholders have shared in its profits.

In 1970, Congress added Freddie Mac, the Federal Home Loan Mortgage Corporation, also a private, for-profit corporation, to provide competition for the recently privatized Fannie Mae.

However, until the Fed's easy-money policy in the years following 9/11, the rate of homeownership barely increased. In 1968, 64 percent of all Americans owned their own home. In 1998, the figure had inched up to 66 percent. The rate peaked in 2004 at 69 percent and is now retreating toward the 1998 rate.

On the other hand, Fannie and Freddie themselves grew and grew. Resisting (and lobbying vigorously against) regulation, the mortgage giants used their special privileges to expand rapidly over the years. They had tax advantages, they could borrow money at lower interest rates than other private borrowers, and they were allowed to hold smaller capital reserves against their liabilities.  This latter “advantage” is what brought them to the precipice in 2008: a few billions in reserve against trillions in liabilities.

Today Fannie and Freddie are by far the largest players in the secondary mortgage market—the place mortgage originators can sell their individual or “whole” mortgages to obtain more money to lend out for still more mortgages. By mid-2008, the two were guaranteeing some 80 percent of all new mortgages issued. They owned or insured some $5.2 trillion of the nation’s $12 trillion in home mortgages.

Still, it is far from clear that the advantages Fannie and Freddie enjoyed as GSEs made much difference for home-buyers. According to a 2005 analysis by Federal Reserve economist Wayne Passmore, at least half the benefits of the implicit guarantee of federal support went to (1) the stockholders, (2) management, and (3) on a smaller scale, the lobbyists Fannie and Freddie paid to prevent Congress from reining in their privileges.

Like Passmore, mortgage expert Jack M. Guttentag of the Wharton School estimates that the benefit for homeowners, on average, is an interest rate reduction of only about .25 percentage points on a typical mortgage.  The comparison that comes to mind is a charity that raises billions of dollars, 90 percent of which goes to the fundraisers.  Another example might be charging tolls on a highway so that the toll-collectors can be paid. 

That said, the primary reason Secretary Paulson gave for the emergency rescue was to help the U.S. economy emerge from its current housing malaise.  With house prices falling across the country, he argued, a key step in reviving the housing industry is to provide liquidity for new mortgage loans, so that potential homebuyers will be able to find mortgages at reasonable interest rates. This function aligns with Fannie and Feddie’s avowed mission, to promote home ownership and advance the American dream.

Still, this argument does not quite seem to explain the dramatic speed of the Congressional and White House response to Fannie and Freddie’s difficulties.

Instead, the sense of political urgency may have stemmed from the holdings by foreign institutions of some $1.5 trillion of the mortgage giants' “agency securities,” the bonds the two companies issue to raise money to plow back into mortgage markets. Over the past decade, Fannie and Freddie’s sales force persuaded foreigners that their mortgage-backed securities were as safe (as free from default risk) as U.S. Treasury securities.

That was never technically the case. Instead, agency bond issues were sold to foreign buyers with a wink and a nod. The implicit guarantee: “If we get in trouble, the government will have to come to our rescue.”

On that premise, foreign governments and institutions bought $1.5 trillion of agency securities. In fact, the $1 trillion rise in foreign holdings since 2001 was fully 40% of the $2.5 trillion increase in agency debt. But in the past few weeks, stories about Fannie and Freddie’s inadequate capital reserves sent their stock prices tumbling. That reminded holders of their bonds that the "implicit guarantee" was not actually binding.

Here was the Argentina moment: the specter of the dollar crisis people have long anticipated. If foreign holders decided to unload Fannie and Freddie’s agency securities because of a fear of default, a panic might grip currency markets, sending the dollar into a downward spiral. Almost nobody wanted that to happen.

The tail was wagging the dog. Bad management at Fannie and Freddie threatened the status of the dollar—and America’s reputation in international capital markets. 

To that extent, the speed and consensus that crystallized in the new housing bill were as much about the dollar as about the housing malaise.  This may be one reason that in his July 21^st speech at the New York Public Library, Secretary Paulson admitted, “I would rather not be in the position of asking for extraordinary authorities to support the GSEs. But I am playing the hand that I have been dealt.”

The hand he was dealt required him to reassure foreign holders of agency securities. As underscored by numerous U.S. embassy phone calls made across the globe, the message he sent out to foreign bond holders was to sit tight and hold on to the agency securities, because the implicit guarantee would be made explicit.

The possibility that this may stick U.S. taxpayers with $100 billion in bailout costs was incidental.  As with some earlier regulatory responses to the continuing subprime meltdown, officials took emergency action in the heat of a crisis. Someone else can worry about the long-term consequences.

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