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The Fannie and Freddie Bailout

CNN:

The Treasury Department and Federal Reserve on Sunday outlined a comprehensive government plan to prop up Fannie Mae and Freddie Mac - the two mortgage finance giants that play a crucial role in the U.S. economy.

Treasury Secretary Henry Paulson said the Bush administration plans to ask Congress to enact legislation to temporarily increase the line of credit that the companies have with the Treasury. It would also allow the Treasury to buy stock in the companies.

Paulson also said the Federal Reserve should be given a greater role supervising the finances of Fannie and Freddie.

In addition, the Federal Reserve announced Sunday that the mortgage finance companies can turn to the Federal Reserve Bank of New York for funds. The move gives Fannie and Freddie the same access to the funds as commercial banks and Wall Street firms. The agency granted investment banks such access earlier this year in the wake of a similar crisis of confidence when investors lost faith in Bear Stearns.

If the plan manages to stablize the situation in the short-term, Congress should consider a long-term plan of complete privatization.

The bailout plan confirms what many Fannie and Freddie critics have argued over the years; namely, that when push came to shove, the government would not let either fail. This implicit government guarantee meant that Fannie and Freddie’s nominal shareholder owners were substantially insulated from market risk and that their management was effectively insulated from market discipline.

The implicit government guarantee—which now has become explicit—thus has had serious adverse consequences. It has encouraged Fannie and Freddie management to take risks that firms subject to market competition and lacking a government safety net would never take. In particular, Freddie and Fannie have increasingly held on to mortgages rather than reselling them as asset backed securities, which exposes them to much higher repayment and other risks.

The insulation from both government oversight and market discipline has allowed serious and well-documented corporate governance problems to persist for years.

Privitization would be ideal. It would expose Fannie and Freddie to competition, which would exert pressure on their managers to make better decisions. It would end the incredibly corrupt relationship between Fannie and Freddie and the Congress, which for years has allowed the mortgage giants to evade real oversight.

The trouble is that the depth of the corruption inherent in the Congress-Fannie and Freddie relationship is so strong that we can confidently predict two things. First, Fannie and Freddie will never be privatized. Instead, it will be back to business as usual. Second, any additional regulation that comes out of Paulson’s plan will prove toothless.