Is It Bailout Time for Fannie Mae and Freddie Mac

By Rick Moran

The TimesOnline is reporting that the federal government is preparing to inject a combined $15 billion transfusion of liqiudity into Freddie Mac and Fannie Mae to keep the two "government sponsored enterprises" from going under.

This is clearly a defensive move on the part of regulators because both concerns are not in any immediate danger. But considering that both mortgage giants lost half their value last week in the stock market, Treasury Secretary Hank Paulson wants to move agressively to keep the two concerns afloat. They wish to send a signal to investors that the government is prepared to do all that is necessary to keep both secondary mortgage lenders in business.

It's a stop gap measure to be sure. As Professor Stephen Brainbridge pointed out in 2005, this has been forseen for many years:

If there really is a housing bubble, both Freddie Mac and Fannie Mae presumably would take a major hit. Is there any alternative to a government bailout if they start down the tubes? I recently found an interesting article by law professor Richard Carnell has lots of good information on the risks we taxpayers are bearing because of Fannie Mae and Freddie Mac's borrowing habit and lousy corporate governance. He also proposes creating a mechanism for dealing with any potential insolvency on their part.

This is an issue that's been flying under everybody's radar screen, but is a key issue given the state of the housing market. Carnell's article is a good introduction to this important problem.

Bainbridge says that this is what happens when you have quaisi government entities not subject to market disciplines. He quotes from LA Times Business Correspondent Tom Petruno:

Fannie and Freddie should have been fully privatized years ago, so that they were subject to market competition; alternatively, although less ideally, they should have been brought back into the government to be regulated more effectively. Leach was right that leaving them as they were was a disaster waiting to happen. And now it looms larger than ever, with potential disastrous implications, as Tom Petruno explains:

On Friday, rumors swamped financial markets that the federal government would be forced to step in to aid mortgage-finance giants Fannie Mae and Freddie Mac, which together own or guarantee $5 trillion in U.S. home loans.

In Wall Street's version of a bank run, investors drove shares of Fannie Mae and Freddie Mac to 17-year lows, signaling a gnawing lack of faith in the companies' ability to survive rising mortgage defaults without government help.

Here we are on Sunday and the government is about to massively intervene once again. I sincerely hope that when this crisis is passed that the entire structure of the secondary loan market is examined and much stricter regulation authorized. To expose the taxpayer to a potential $5 trillion loss should be criminalized. Perhaps then more care will taken to avoid the situation we're in today.