One would think that policymakers would treat the day before Christmas as sacrosanct, if not for the sake of their employees, but to avoid the endless conspiracy theories that naturally arise when you partake in activities that look like they are intended to fly under the radar. Has US Treasury Secretary Timothy Geithner learned nothing in his long tenure serving Goldman Sachs the people of the United States of America? Ignoring the wisdom of the ages, Geithner made what appears to be unlimited funds available to Freddie Mac and Fannie Mae on the day when most of the nation is more concerned about getting presents under the tree (myself personally content that I can squeeze yet another year of magic under the Santa Claus myth) than the policy machinations of Washington.

But do we really care? Is this really a new news, or just a matter of questionable timing? Would the same announcement today have raised the ire of the blogshpere?

To get at this issue, we should back up to a New York Times article a few weeks back (hat tip toDean Baker):

Fannie Mae and Freddie Mac, which buy and resell mortgages, have used $112 billion — including $15 billion for Fannie in November — of a total $400 billion pledge from the Treasury. Now, according to people close to the talks, officials are discussing the possibility of increasing that commitment, possibly to $400 billion for each company, by year-end, after which the Treasury would need Congressional approval to extend it. Company and government officials declined to comment.

Apparently this little item was lost in the Christmas rush - seriously, could this even compare to the endless fascination with the status of holiday sales? The point is that hanging in the background was the likelihood that Mae and Mac were expecting some very, very bad fourth quarter numbers. Indeed, despite the massive efforts to support the housing market, Fannie Mae reported today that serious delinquencies continue to climb at an alarming rate. So, at second glance, Treasury's Christmas Eve announcement looks somewhat less disconcerting. The timing questionable, but the outcome expected. But why the essentially unlimited access to funds? I think this is pretty straightforward - Geithner simply lifted illusion (delusion?) that the GSEs were anything less than backed by the full faith and credit of the Uncle Sam. Seriously, at this juncture who believes that GSE debt is any different than Treasury debt? Or that the US will not pump into any amount of dollars necessary to keep the GSEs afloat?

That said, the Treasury's press release was bereft of explanatory information, giving rise to a host of theories as chronicled by Calculated Risk. In my mind, the most appealing of these explanations (other than that stated above) is the supposed intention to use the GSEs to absorb dysfunctional mortgages in an effort to revive floundering modification programs. Why? Because, as structured, modifications just simply don’t work in aggregate. I have thought this from day one of the modification story. And, frankly, I don’t think I am particularly insightful on this point. Seems obvious. Suppose homeowner A is underwater on a mortgage costing $4,000 a month for a property that now has a rental equivalent of $2,000. How exactly does it help that homeowner to "modify" their mortgage to $3,000 a month? They are still underwater, and they will likely have to sacrifice any potential gains (10-20 years down the road!). The modification leaves you with the choice of being a virtual renter for $3,000 a month or an actual renter for $2,000 a month. Moreover, what truly is better for the economy? To free up $2,000 in the household's monthly budget via a balance sheet restructuring, or to weigh down the household balance sheet with an impossible debt burden?

The Wall Street Journal recently printed a front page article on this topic that I thought was spot on:

Analysts at Deutsche Bank Securities expect 21 million U.S. households to end up owing more on their mortgages than their homes are worth by the end of 2010. If one in five of those households defaults, the losses to banks and investors could exceed $400 billion. As a proportion of the economy, that's roughly equivalent to the losses suffered in the savings-and-loan debacle of the late 1980s and early 1990s. The flip side of those losses, though, is massive debt relief that can help offset the pain of rising unemployment and put cash in consumers' pockets. For the 4.8 million U.S. households that data provider LPS Applied Analytics estimates haven't paid their mortgages in at least three months, the added cash flow could amount to about $5 billion a month -- an injection that in the long term could be worth more than the tax breaks in the Obama administration's economic-stimulus package. "It's a stealth stimulus," says Christopher Thornberg of Beacon Economics, a consulting firm specializing in real estate and the California economy. "The quicker these people shed their debts, the faster the economy is going to heal and move forward again." As the stigma of abandoning a mortgage wanes, the Obama administration could face an uphill battle in its effort to keep people in their homes by pressuring banks to cut their mortgage payments. Some analysts argue that's not always the right approach, particularly if it prevents people from shedding onerous debts and starting afresh. "The effect of these programs is often to lead homeowners to make decisions that are not in their economic best interests," says Brent White, a law professor at the University of Arizona who has studied mortgage defaults.

The sorry truth is that many households underwater on their mortgages are likely better off defaulting (this is not a suggestion to strategically default; consult your attorney when contemplating that option), and so likely is the economy as a whole, than accepting a modification that does not involve a significant principle reduction. The only people who do not recognize this are, sadly, policymakers, who have trouble comprehending the possibility of a bubble that led to prices far above ability to pay. Such a delusion extended to the highest levels of the Fed. Arguably, the push for modifications is simply more evidence that Washington is more concerned with the interests of Wall Street than Main Street.

Hence why the Treasury's blanket coverage of the GSEs leads to speculation that the Administration intends to more aggressively use their portfolios to push for principle reductions. Such reductions, obviously, actually help households, but at a cost to the taxpayers that leaves mortgage asset holders nearly whole. Such reductions would also wipe away any remaining delusion that the trouble in housing is a liquidity issue rather than a insolvency issue. To be sure, I would indeed not be surprised to see an enhanced modification effort via the GSE s that push greater costs onto the taxpayer, especially with respect to the mortgages still held by Mae and Mac. But to dig deeper into the issue, I think the GSEs would need to aggressively purchase privately held mortgages with the potential for liquidation. And here this paragraph in the Treasury release sticks out:

Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. FHFA will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the PSPAs.

So Mae and Mac are not required to sell part of their portfolio into a declining market (which would exacerbate the loss to taxpayers), but nor would they be expected or really allowed to expand their portfolio to ease the process of modifications on the back of the taxpayer. Moreover, even an effort to expand modifications does not appear to be within the FHFA's conservator responsibilities. Which would, if I am reading this right, suggest that while there are plenty of reasons to believe that the modification program is fundamentally a failure, Treasury's Christmas Eve announcement is not a backdoor effort to expand the socialization of mortgage losses. Yet.

In short, there are plenty of ulterior motives for Treasury's expansion of the Mae and Mac bailouts. My favorite is the desire to expand the ability of the GSEs to absorb principle reductions for housing modifications. But the simplest explanation is likely the correct one - the financial damage to the GSEs continues virtually unabated, and the Treasury simply needs to make explicit what was implicit: Mae and Mac are backed by the US government's full faith and credit, regardless of the level of losses in those institutions. I don't think this is really an expansion of the bailout; more just a confirmation of my prior beliefs.