The End of an Era
Posted on: September 7, 2008 - Email Article - Printable Version
It appears the era of the “government-sponsored enterprise” with an ‘implicit-backing’ of the government has come to an end. On Friday, the federal government prepared to take control of Fannie Mae [[FNM]
] and Freddie Mac [FRE: 0.82, +0.09 (+12.33%)]. The move to place them in a conservatorship brings about a whole host of issues for the Treasury and the Fed. I think perhaps the most interesting of these concerns is the implications this has with foreign governments and their investments in the United States. Don’t think Hank Paulson, a true conservative at heart, doesn’t know he has little choice in the matter. Allowing agency debt to default would be the equivalent of political (and economic) suicide for the U.S.
While I think many would like nothing more than for the government to allow these two entities to run their natural course and possibly fail…I can assure you the political and economic backlash for such actions would be far worse than a couple billion dollar bailout. The government’s allowance of the idea of an ‘implicit backing’ to proliferate for so many years to me means that they have made their bed…a bed they must now lie in. I guess the problem with the government lying in their bed is that it really means that you and I will be paying billions of dollars for them to get to sleep.
Aside from the foreign affairs implications, let’s not forget that a precedent has been set when the Treasury decided to step in and pledge its own capital to Bear Sterns. This, mind you, for an entity that does not nearly have the affiliation or political clout in Washington that Fannie and Freddie carry.
Four More Years?
While my feelings on the government’s actions won’t be decided until more details emerge, I think the Treasury’s decision to act now as opposed to later is a positive. One of the largest and most unprecedented economic decisions in our country’s history, President Bush has very little at stake in this matter. However, a decision like this for the new president-elect would undoubtedly set the tone for his next four years.
A Scapegoat in the Making
In a recent conversation with a long-time friend who has never been shy to enlighten me as to his disdained opinion of Wall Street, I was quick to remind him ‘Wall Street’ has allowed him access to capital for everything from his student loans to his family’s mortgage. I will be the first to admit that the idea of “government-sponsored enterprises”, with an implicit backing of the government yet a responsibility to its shareholders, is at best highly questionable. However, moral hazard issues aside, this implicit subsidy has undeniably provided lower priced housing to people across the U.S. socioeconomic spectrum.
While the business model of the GSEs will and should be called into question, my biggest fear is that a nationalization of Fannie and Freddie will allow them to become the scapegoats for our present financial crisis. The investment banks have no doubt been looking to shift the blame elsewhere. And what better target than the government? Yet it was not Fannie and Freddie that caused the collapse in the housing market. In fact, their growth since 2003 has been extremely limited. At the heart of this downturn is sub-prime lending (from which GSEs are restricted), where investment banks’ lending standards collapsed in an effort to keep pace with the securitized mortgage market. Fannie and Freddie may have contributed to the housing problems as the government leaned on them to keep the lending market liquid as the rest of the market tightened; however I would place that blame more on the government’s shoulders.
Moving Forward
With no real competitors, determination of Fannie and Freddie’s appropriate capital requirements, asset exposure, etc, will be difficult. Additionally, excluding possibly the government’s backing of the FDIC during 
the Savings & Loan crisis, the nationalization of such entities is unprecedented in the U.S. Moving forward, the government is swimming in unchartered territory with the outcome of the entire situation far from certain.
As a side note, the debate of nationalization vs. privatization of the GSEs is nothing new. Former Fed Chairman Greenspan stated numerous times the only “long-term solution to the GSE problem is to privatize them.” In a 2003 article I came across from the 40th Annual Bank Structure Conference sponsored by the Federal Reserve Bank of Chicago, Bert Ely discusses the problems with the GSEs and his proposal to privatize them. A bit lengthy but worth the read. It appears the government has missed their chance for such actions and must now take the problems of Fannie and Freddie onto their own books.
-Adam Brown
Disclosure: None
The Following Stocks Were Mentioned In This Article: FNM, FRE
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What does the phrase command economics mean to you? What about the phrases market forces and market discipline? The decades long dubious business and accounting practices of Fannie and Freddie played no part in the creation of the housing bubble? What about the mortgage tax deduction? And most of all what about the inflationary fiscal and monetary policies for most of the last 45 years, culminating in a 1% prime well below the official inflation rate and way below the real rate?
This delusional country is dominated by command economics/redistribution and calls it capitalism. Do you know better or are you just playing along?
Median,
Do not misinterpret what I am saying. The moral hazard issues raised by the GSEs business model clearly came to surface over the past twelve months. Additionally, any entity that owns or guarantees half of the market at the root of any economic downturn (in this case the mortgage market), will clearly be a contributor to the problem. My point, however, is that there was no reason for the business models to stop functioning now after thirty and seventy years other than the investment banks’ subprime lending.
Additionally, as I pointed out in my article, as the rest of the market tightened its lending standards, the government leaned on Fannie and Freddie to keep the housing market liquid. While this was clearly a contributor to their problems, the blame should not be placed on the actual GSE entities. My biggest fear is that Fannie and Freddie will take the fall for our current economic downturn and leave the investment banks and the government (for allowing the idea of “government-sponsored enterprises” to proliferated for so long) unreformed.