Fannie and Freddie: Bail 'em out, then bust 'em up


Fannie and Freddie: Bail 'em out, then bust 'em up

Jul 28, 2008 2 min read

Former Norman B. Ture Senior Fellow in the Economics of Fiscal Policy

J.D. served as the Norman B. Ture Senior Fellow in Economics of Fiscal Policy

News that the Treasury is preparing plans to bail out housing finance giants Fannie Mae and Freddie Mac (FM2) has infuriated the American people. And rightly so: It's their money, after all, on the line. If they understood the whole truth, they'd be even angrier - but they should vent their fury at the guilty parties

Washington has played a tidy little game with "FM2" for years. Congress created them to make more homes more affordable to more people. Part of their financial success lay in the implicit guarantee that if they ever got into financial trouble, the federal government would bail them out.

FM2 officials have long denied any such guarantee. They were flat-out wrong. Congress on a largely bipartisan basis has said for years that FM2 were perfectly sound, well-run institutions and no bailout would ever be necessary. They were, at best, conveniently misinformed.

Bush administration officials (in a break from its predecessors) have said repeatedly that FM2 weren't too big to be allowed to fail, and so it would never offer a bailout. They were hopelessly hopeful. The effect of being too big to fail is that there's always an implicit guarantee the federal government will send a financial ambulance to your rescue if you get into deep trouble. This guarantee allowed FM2 to borrow at a discount, propping up the profits that have gone to their shareholders and bondholders. Thanks to these profits, FM2 had plenty of resources to maintain one of Washington's most powerful lobbying forces, backed by serious campaign cash. And this was the tidy little game: Congress would defend FM2 against reforms that would diminish their outsized profits, and FM2 would funnel a portion of their profits to their congressional friends. Many of those congressional friends are now those writing the reform bills.

The administration's hopeful protestations were accompanied by repeated public warnings of possible troubles ahead. The seeds of trouble were all there: enormous size, inadequate capitalization, single industry focus, heavy political involvement. The administration was joined by legions of officials from the Federal Reserve, international organizations, think tanks and private citizens - all warning that FM2 presented an enormous systemic risk to both the housing and financial sectors.

In short, if one or both of FM2 got into real trouble, they could topple for a period the entire global financial system. The warnings were as right as they were unheeded.

Now the mess is upon us. The time for prevention is long past, and we have to make the best of it. In good times, perhaps the financial system could readily weather allowing either or both of FM2 to go down the drain. That's not the case today. The financial system is already struggling. The Treasury and the Fed must be authorized and equipped to respond to FM2 founderings to maintain orderly markets while the economy sorts through the housing debacle, the credit crunch, high energy prices, and whatever else strikes a blow. Treasury and the Fed are the ambulance crew trying to keep FM2 going - for now. Americans should direct their anger at Congress, which for years refused to heed the warnings, even as it worked to protect its gravy train of political contributions.

Anger isn't enough, however. As Congress readies a bloated housing bill, Americans should demand Congress ensure this kind of financial threat never looms again. Strengthening the federal regulator for FM2 is fine, but we really need to break these financial goliaths into many, much smaller and truly private companies. Unfortunately, there isn't time now to scheme the breakup of FM2 properly. Instead, Congress should separately task the General Accountability Office and the Federal Reserve with producing a study with its recommendations on how FM2 might be restructured into a variety of private, separate companies. Once cut down to size and properly regulated, these new companies would pose little risk in and of themselves, would never become too big to fail, and so would lose their implicit guarantee of a future bailout. It's not enough to call in the ambulance. We need to catch the mugger who perpetrated this crime-and make sure he never haunts the neighborhood again. 

J.D. Foster is the Norman B. Ture senior fellow in the economics of fiscal policy at The Heritage Foundation.

First appeared in The Salt Lake Tribune