The Fannie-Freddie bailout is a bad idea and won't work. But for some, it's the only answer. Why?

Fannie and Freddie guarantee about half the U.S. mortgage market. If they simply go away, so does the conduit for some $5 trillion in home loans. The implications are dire: mortgage rates rise because lenders would have to hold mortgages on their books, and they'll want to get paid for that. Homeownership falls.

So, Treasury Secretary Hank Paulson believed a bailout was the answer. The objectives: "Providing stability to financial markets." Fine. But I'd rather see short-term instability that leads to long-term stability, than vice versa.

"Supporting the availability of mortgage finance." The too-easy availability of mortgage finance caused this mess in the first place.

"Protecting taxpayers." How? By "minimizing the near-term cost to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure."

This begs three questions.

First, is it wise to minimize the near-term costs to taxpayers with a plan that will likely maximize both long-term costs and their duration?

Second, since when has unleashing policymakers on a problem protected taxpayers? (Some of us recall the S&L crisis.)

Third, if Paulson recognized the systemic risks inherent in the GSE structure, why didn't he start fixing it in July 2006, when he was sworn in--before it was too late?

Paulson's plan is to place Fannie and Freddie in conservatorship--supposedly a temporary parking spot for companies deemed insolvent until they can return to solvency. All too often, it's the purgatory to receiver-ship's hell.

The plan replaces management. Fannie's CEO was replaced by a former Merrill Lynch vice chairman. The same Merrill Lynch that has lost $51.8 billion over the course of the credit crisis, placing it No. 2 on the loss-leader board and costing stockholders 70% of their

investment. The same Merrill Lynch that is vying with Lehman Brothers to be the next Bear Stearns. Hard to like this pick.

The Treasury will become a senior preferred stockholder in Fannie and Freddie in exchange for "ensur(ing) that each company maintains a positive net worth." Note that Paulson didn't say the Treasury would maintain adequate capital for the pair, just "positive net worth." He said, "Their statutory capital requirements are thin and poorly defined as compared to other institutions." Well, they're well-defined now: anything above zero. But that's still a tad thin. The Treasury will also ensure--until the end of 2009--that Fannie and Freddie have positive net worth. So, if the losses continue mounting and the net worth goes below zero, Treasury will keep providing money--taxpayer money.

Fannie and Freddie will have two primary missions. Each will "proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability."

After recognizing they'd been too low to reflect the risk of the underlying mortgages for years, Fannie and Freddie only recently upped their fees. Now, Paulson wants to lower those fees, back to submarket-risk levels.

Second, the GSEs' mission will be to "Modestly increase their MBS portfolios through the end of 2009. Then to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10% per year...eventually stabilizing at a lower, less risky size."

Read between the lines: Paulson knows increasing the size of their portfolios--even into 2010--increases "systemic risk," and he admits shrinking their portfolios to a "lower, less risky size" would reduce risk. So, he proposes increasing their portfolios short term, thus increasing the risk of losses to taxpayers. Also, the housing crisis isn't expected to end until year-end 2009. So, just when the party could be getting started, they'll take away the punch bowl.

What's worst about the plan is it won't stimulate housing demand. The Fed and the Treasury have been intervening in the credit markets since last summer. What has the effect on housing and mortgage affordability been?

Home prices continue to fall, reaching fresh year-over-year records every month. Delinquencies and foreclosures continue to rise. And mortgage rates have fallen just 35 basis points--and that's only come since the bailout. Not a huge difference in the monthly payment on a non-jumbo mortgage.

The actual effects of the bailout will include: Fannie's and Freddie's stockholders will get nothing. That's appropriate. When you buy stocks, you risk losing your money.

Mortgage rates won't go down meaningfully enough to stimulate housing demand. The weakness in demand is a function of still-bulging housing inventories, producing still-falling prices. Nobody wants to jump on a sinking ship. Until prices bottom out, we won't see a recovery.

This won't meaningfully increase mortgage credit issuance. Lending standards have tightened. So, even if rates drop enough to make houses affordable, many borrowers won't qualify or be able to raise the 20% down payments now required.

Taxpayers lose. This year's budget deficit is already expected to top $400 billion. This bailout will cost taxpayers an estimated $300 billion.

Put it in perspective: The S&L bailout ultimately cost taxpayers about $125 billion. According to Wikipedia, it "contributed to the large budget deficits of the early 1990s" and "ended up being even larger than it would have been because moral hazard and adverse selection incentives compounded the system's losses." There's no lack of moral hazard or adverse selection incentive in this bailout.

There may be another cost. When Paulson first petitioned for blank-check authority to bail out Fannie and Freddie--while saying he didn't expect to actually have to use it--S&P said that if the Treasury bailed out the pair, ratings on U.S. Treasuries might have to be reviewed.

An unprecedented statement, with huge implications. Higher Treasury borrowing costs, leading to higher mortgage rates. And even if the debt isn't downgraded, how will China and Japan feel about buying U.S. Treasuries now that we've further increased the national debt? They'll demand higher yields and get them. And up go mortgage rates.

Everyone from former Fed Chairman Alan Greenspan to Democratic Presidential Nominee Barack Obama and Republican Presidential Nominee John McCain to Warren Buffett is saying this had to be done--Paulson had no choice. I disagree. There was a better solution: Let them fail.

Pony up enough money to protect bondholders because the credit markets would truly collapse if the bonds defaulted. But let stockholders lose their money, which will happen anyway.

As for the availability and cost of mortgage credit, let the market determine that, as it should. Let private insurers step up to insure mortgages based on their inherent risk. So what if homeownership winds up onlybeing affordable for those who demonstrate financial responsibility, those who save up a reasonable down payment, pay their bills on time and can actually repay their mortgages?

Brian Hague is president/CEO of CNBS, a securities brokerage, investment advisory and outsourced ALM reporting services firm. He can be reached at 913-402-2642 or
[email protected]