By John Cranford CQ Columnist
Published: 07-29-08
The challenge facing Peter Orszag and his staff at the Congressional Budget Office last week was extraordinary. Essentially they were supposed to outguess the best guessers in the world — the ones that make tons of money on Wall Street by taking the most outlandish bets.
In this case CBO had the unenviable task of estimating how much a bill to rescue mortgage giants Fannie Mae and Freddie Mac might eventually cost the taxpayer should the losses on their combined $5.2 trillion portfolio of mortgages and mortgage-backed securities increase and the two companies have trouble persuading investors to roll over their $1.5 trillion in debts.
The headline was a cost estimate of $25 billion through 2010 and it will be quite some time before we know how well the folks at CBO did with that. But it’s really not worth worrying about because it’s the details of the estimate that mostly didn’t get reported that say something significant about the state of the economy and market forces and that make it interesting.
In truth the budgeteers were sent on a fool’s errand that had little real consequence at all: The precise cost estimate was irrelevant to the debate over the rescue bill because it wasn’t a factor in lawmakers’ decisions. Many would have voted for the measure regardless of the price tag and many who opposed it would have done so had the estimate been much smaller.
Moreover as the CBO forecast suggests in its most careful language this is a prediction that almost cannot be made because the possibilities range from no-cost-at-all to the-sky’s-the-limit. The conditions that will determine where the expenses fall along that spectrum are quite fluid. All CBO could do was run through the possibilities and assign probabilities to each of them. The result was a number that looks like a cost estimate but really isn’t.
Consider first that CBO took pains to say repeatedly that this rescue bill may never be invoked to actually put cash into the accounts of Fannie or Freddie. That’s because the plan is designed to reassure investors from here to Beijing that their money is safe so they’ll keep lending to Fannie and Freddie even if the losses mount.
Treasury’s promise of an emergency loan or stock purchase serves as an insurance policy that may never be used. And in CBO’s view the odds are better than 50-50 that Treasury won’t pony up a cent before the rescue package expires at the end of next year.
At the other extreme CBO puts the probability at 5 percent that an infusion of cash greater than $100 billion might be necessary. That’s not a very high probability at this point but $100 billion does look like real money. By comparison a figure like $25 billion looks more like a rounding error in today’s world of $3 trillion budgets $900 billion wars and $400 billion deficits.
Looking Closer
Regardless the take-away point for taxpayers and investors alike last week ought to be that the housing crisis is going to get worse that Fannie and Freddie really are in a deep hole and that they may very well need a lot of help to climb out.
CBO made a point of saying that the two companies had a collective net worth of $7 billion in March — an amount very close to zero relative to the size of their liabilities — under a concept called fair-value accounting. That method treats their mortgage holdings and other assets as if they had to be sold today not as if they are still performing and as a result it scores those assets at much less than their original value. It’s only one way of looking at the books but it’s very telling about their condition.
On top of that came a drumbeat of bad housing news. Sales of existing houses fell in June to their lowest level in a decade while the median home price was 6 percent lower than a year ago and there were enough houses for sale to meet almost a year’s worth of demand.
Moreover both foreclosure rates and mortgage loan rates are rising and the Census Bureau reported a record 18.6 million vacant houses and apartments in the second quarter.
Bill Gross of Pacific Investment Management Co. who is manager of the world’s biggest bond fund and is to that market what Warren Buffett is to stocks predicted that bank losses on defaulted mortgages will surpass $1 trillion — out of $12 trillion in home loans overall. Some of that will fall on Fannie and Freddie.
Yet perhaps one of the more telling developments in the marketplace was that investors started demanding less of a premium to lend money to the two companies. The difference between what Fannie and Freddie pay in interest on their borrowing and what the Treasury pays is a good proxy for how risky investors think it is to lend to them.
Ordinarily the spread is quite small but recently it has been widening. Late last week however as Congress got closer to enacting the rescue bill — and as housing-market conditions deteriorated — the spread narrowed. At the same time stock prices for the two companies started falling again.
That’s not a sign that investors are more comfortable with the outlook for housing or for Fannie and Freddie. Rather it’s a clear indicator that they are certain Uncle Sam will pitch in if things get worse. And things will. CBO and Bill Gross are betting on it.
