Dissolve Fannie Mae And Freddie Mac

The Chinese symbol for crisis also can be expressed as an opportunity. The current collapse of confidence in the domestic system of finance and financial leadership provides such a potential moment. The three part proposal to rescue Fannie Mae [[fnm]] and Freddie Mac [[fre]] has bestowed upon our political and economic leaders the responsibility of ensuring that no one company again becomes too big too fail.

The crisis requires more than the avoidance of moral hazards. Rather, the solution to the current financial crises and its legislative response requires that no firm or enterprise ever again be permitted to obtain an implicit guarantee of Federal largesse. Fannie Mae and Freddie Mac need to be taken under federal protection, its assets used to cover the risk of the taxpayer bailout and its charter legislatively dissolved.

The initial steps taken by the US Treasury and the Federal Reserve are necessary but not sufficient to engage in the type of systemic reform concomitant with the failure of Fannie and Freddie. Preserving the government sponsored mortgage giants in their current form is exactly the wrong step to take at this crucial juncture. In particular, the blank check that the US Treasury has requested is more than a bit troubling. Even in the aftermath of 9-11, the Bush administration was not given an open-ended account to pursue Al-Qaeda.

Just as important are the implications for the US balance sheet, the US dollar and the interest rate environment should Washington absorb the liabilities of the failed government sponsored enterprises. If the rescue of the government-sponsored enterprises are not handled properly, the US taxpayer will find themselves on the hook for trillions of dollars of liabilities, not to mention the outsized risks to the US dollar and higher interest rates that would occur if the rescue of the Fannie and Freddie were to be botched.

What is next the monetization of the coming insolvencies at Ford and GM, not to mention the future collapse of Medicare, Medicaid, and Social Security?

We are not surprised that in a real crisis that the socialist paradise that Washington sometimes resembles is advocating a wholesale takeover of Fannie and Freddie. In fact, the discourse emerging from the apologists for Fannie and Freddie has been that the GSE’s remain stout and that they represent the last best hope for containing the damage from the implosion in the domestic housing sector. The current approach favoring the use of taxpayer money to preserve the status quo is the very essence of why we stand mired deep in the financial crisis that we do.

It is fair to say that conventional wisdom among the majority in Congress is that both Fannie and Freddie are useful tools for the state to pursue social goals. The market inefficiencies and risk to taxpayer funds from politically based enterprises are legitimate since they to provide the Federal Government to provide low-income individuals with the means to purchase a home.

In fact, I expect that in the coming weeks that the usual suspects that have protected Fannie and Freddie over the years will call to make them non-for-profit organizations with public guarantees to protect the financial and political privileges that have accrued to the GSE’s and their political clients over the years.

Defenders of the GSE’s will state that they have been “private” since the early 1970’s and that the backing of the Federal Government has always been “implicit.” We beg to differ. An implicit guarantee is tantamount to being “a little bit pregnant.” Either you are or you are not. There is no such thing as an implicit guarantee and the explicit use of taxpayer money that will be used to bailout the GSE’s is a function of that “implicit” guarantee.

Given the current level of risk to both the domestic and global system of finance the Treasury needs to act in a much more provocative fashion than it currently is signaling. The Treasury should take the following steps:

First, the US Treasury Secretary through the administration should request authorization from the Congress to put Fannie and Freddie under direct Federal supervision. To specifically protect taxpayer interests, the operation of the twin giants should be directly and forever removed from the political process.

Second, the senior management at both Fannie and Freddie should be removed from their positions forthrightly and the Congress should commission and investigation into exactly how both GSE’s arranged to avoid the type of transparency that would have avoided such a calamity. Washington may think that it will be able to buy itself out of this one, but once the public gets a whiff of what the costs of the bailout are going to be some very important political actors on the Hill may not be too excited about their future electoral prospects.

Third, the Congress, the Treasury and the Fed should move with all deliberate speed to set up a 21st century version of the resolution trust corporation. A move to create a new RTC would get out ahead of the curve of the wave of banks that will fail later this year and in 2009. The Federal Reserve currently has a list of 90 banks on watch for failure and it is imperative that the Federal Government begins to get ready for the probability of a wave of failed banks.

Most importantly, the Treasury and the Federal Reserve should make it clear that any regulatory reform in the pursuit of the notion that any firm that is too big to fail, also applies to Fannie and Freddie. The genuine systemic threat posed by the failure of the GSE’s requires that what remains of them in the aftermath of the crisis be privatized.

The public should never again tolerate a firm that operates as a privileged enterprise, free from market discipline and able to shield itself from accountability through the deft manipulation of the political process.

The role that Fannie and Freddie carved out for itself in the mortgage market was not one of innovation, service or demand, but rather was obtained vis-à-vis its implicit government guarantee. The failure of Fannie and Freddie is not one of the market, but one caused by a government that remains far too large.

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Comment by tom sowanick

2008-07-19 10:15:31

Grace, i agree with your general theme that government has become to large and that the blank check approach by the U.S. Treasury is dangerous. Where I differ is in the view of whether the GSE’s need to exist at all. The housing agency’s were created to provide a financial medium for potential homeowner’s in the US. They have succeeded in that primary goal. The implicit guarantee of the government has allowed for these institutions to morph into hedge-fund like institutions with below libor funding (prior to 2007 crisis) which allowed them to grow beyond their natural roles. I suggest that the government cut them free, let them go to the open market for financing and see if they survive. Perhaps by allowing them to enter into the free market’s without implicit or explicit guarantees new mortgage underwriter’s will emerge with proper controls and risk management.

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Comment by Grace Cheng

2008-07-20 17:27:32

Hi Tom,

Just to clarify this great post was written by Merk Fund, a contributor to GraceCheng.com.

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