Lenders may be better off out of federal hands

Freedom New Mexico

So what happened Sunday night, when Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke announced that Fannie Mae and Freddie Mac would get government backing to keep them from failing?

It seems to have prevented a major meltdown of the two government-sponsored enterprises (GSEs), but it’s a short-term fix that could fall apart, especially if the housing market continues to decline and defaults increase.

The Federal National Mortgage Corporation (Fannie Mae) was founded in 1938 as a government agency to provide liquidity to the mortgage market by buying mortgages from primary lenders, reselling packages of them to investors and collecting fees on the transactions. In 1968 it was converted to a “private” corporation, and in 1970 the Federal Home Loan Mortgage Corporation (which goes by the not-so-obvious acronym of Freddie Mac) was formed to provide competition in the secondary mortgage market.

Until Sunday, it was never explicit that the two firms would have direct access to government money in case of serious trouble, but most people in the financial markets figured the government considered them “too big to fail.” So they were considered safe investments, and the “spread” between the mortgages they bought and those they resold was fairly small. Fannie and Freddie own or guarantee $5 trillion in mortgages, have contracts with other institutions to hedge risks on $2 trillion more, and have debts of $1.5 trillion.

However, as the subprime mortgage market began to collapse, leading to defaults and the bottom falling out of the housing market, both companies got into serious trouble — on top of accounting scandals in the early years of the decade. Last week their stock prices fell more than 50 percent and government officials figured that if they really collapsed the ripples would cascade through international financial markets, raise the government’s cost of borrowing, put downward pressure on the dollar and bring mortgage underwriting to a screeching halt.

So on Sunday night, Treasury Secretary Henry Paulson announced the two entities would immediately have access to the Federal Reserve’s discount lending window, and the skids were greased for legislation to allow the Treasury Department to offer loans or even to buy stock in the two companies. The hope is that neither lending authority will have to be used, but that the government’s involvement would calm the financial markets.

We talked to Peter Wallison, an economist at the American Enterprise Institute who follows these issues closely. He told us the emergency procedure worked, at least for now. Freddie Mac was able to sell $3 billion of debt, and while the stock price of both companies declined, it didn’t amount to a meltdown.

In the long run, Wallison says, there are three options: privatizing the two companies for real, nationalizing them, or muddling through. He favors the first, since it “would subject them to market discipline, which is much more effective than regulation at deterring unsafe behavior,” but thinks it’s a long shot. If the housing market continues to erode, however, it could become a more politically realistic option.