Reliving the savings and loan meltdown?

It was the worst of times -- or maybe not so bad. Such was the tale of three conference calls. Merrill Lynch sold $30 billion of subprime mortgage-related debt to a hedge fund for 22 cents on the dollar. Does that mean the houses underlying these debts (assuming an improbable 100% default) are worth only one-fifth of what owners paid for them?

Whereas Freddie Mac and Fannie Mae avoided any big writedowns of their dodgy "Alt-A" mortgages, on grounds they don't need to sell these to any hedge funds and will hold them to maturity, when they will be seen to have paid off after all.
[Reliving the S&L Meltdown]
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Daniel Mudd, president and CEO of Fannie Mae, and Richard Syron, chairman and CEO of Freddie Mac, at a Capitol Hill hearing.

So Merrill's houses are worth 22 cents while Fannie and Freddie's are worth a buck?

You can reasonably posit the truth lies in between, even given the depressed credibility of all three CEOs. You can also learn a lot about the subprime state of play. The Merrill story shows how dubious mortgage debt came to be distributed far and wide, souring confidence in financial institutions. It also shows why the solution is to move these damaged credits off the balance sheets of publicly traded financial institutions (whose investors can't see through the murk and don't trust management) to private investment partnerships (whose investors can and do).

For their part, Fannie and Freddie demonstrate why these two are now the cleanup's biggest foot draggers, posing a giant risk to taxpayers.

Merrill's John Thain has caught hell from reporters and analysts because Merrill's losses have been a moving target, and because his efforts to shift assets seemed a tad cosmetic, given that Merrill agreed to finance 75% of its own fire sale. But the stock market applauded anyway. The knockdown price, more than the boss's strained credibility, was investors' best assurance that the IOUs won't return to Merrill again.

In contrast, simply nobody believes a word Fannie's Daniel Mudd and Freddie's Richard Syron are saying, because their interest now is in delaying recognition of any losses and gambling on a turnaround, using the government's credit card.

That gamble may be looking more hopeless by the day, judging by their share prices. But Congress just increased the size of the mortgages they can buy. Washington has all but thrown itself on their mercy to keep the housing market afloat. In theory, Fannie and Freddie can now Ponzi themselves to the sky -- the capital markets will continue to finance them no matter what losses they store up, or even whether they appear to be solvent.

Their only vulnerability now is political-technical -- their sinking and increasingly mirage-like capital ratios, which might embarrass Treasury Secretary Hank Paulson, our new president-plus for the economy, into blowing the whistle.

In effect, we are reliving the S&L crisis, with two giant S&Ls gambling on survival with taxpayer funds while politicians summon the will to act. Fannie and Freddie have started lending new money to delinquents to avoid foreclosures; they're dangling cash incentives in front of loan servicers to delay recognition of hopeless cases. To preserve their mostly symbolic capital, the duo also are cutting funding for new mortgages (or at least saying so to drive up mortgage spreads) just when public policy has delivered us into total dependence on them to finance home sales.

Who knows when the terminal market panic will come, forcing Mr. Paulson's hand, but it surely was helped by this week's Barron's story pronouncing Fannie and Freddie doomed.

In the meantime, the cost to taxpayers can only go higher -- Mr. Paulson would be unwise to assume Fannie and Freddie's current managements are doing a better job of earning their way out of trouble than a government receivership would. Just the opposite: Management has every reason to go for broke, risking any amount of future taxpayer losses in hopes (however faint) of shareholders living to see another day. Mr. Paulson's clear duty is to revoke these incentives before they bury us all. At this point, doing so would probably lift the entire financial sector.

And then? Make sure we never get here again by breaking Fannie and Freddie up, returning their functions to the private sector and (if we really feel more subsidy to homeowning is needed) insisting that Congress do it the fiscally honest way, through the tax code.