Janet Albrechtsen Blog | July 23, 2008 | 15 Comments
IF you don’t read the financial press, Fannie Mae and Freddie Mac may sound like a quaint but ailing American aunt and uncle.
One bit is right. They are sick. These two sweet sounding government-sponsored institutions responsible for almost half of the $US12 trillion ($12.3trillion) mortgage market in the US have become mortgage monsters that could wreak havoc on the international financial markets. Too big to fail, they totter on the brink, their only lifeline a federal government now pledging American taxpayer dollars to prop them up. There is a punchline, though. Right now, there are calls in Australia for our own federal Government to create our very own Aussie Mac. As generation text would say, LOL.
Americans are only now waking up to the dud deal behind Aunt Fannie and Uncle Freddie.
As always, it was done with the best of intentions. During the Depression, Fannie was the New Deal corporate white knight, the government-sponsored saviour of the American dream. Created in 1938 by president Franklin D. Roosevelt, it was charged with financing cheap house mortgages for Americans when credit was tight.
But Fannie, and her younger sibling Freddie Mac, created in 1970, represent the very worst form of corporate socialism: private profits and public risk. Backed by an implicit government guarantee: meaning executives, shareholders and clients understood the government (read taxpayers) would bail them out if needed, Fannie and Freddie grew and grew, generating huge profits for their executives, shareholders and the big Wall Street firms with whom they did business. It all seemed so clever. But last week the tab for that social experiment was delivered to US taxpayers.
It started unravelling 10 days ago when the share price of the two government sponsored enterprises fell 50 per cent, on top of their plunging market capitalisation over the past year that has seen joint losses of $US10billion. After assuring Americans that all was well with Fannie and Freddie, US policymakers and Treasury officials proposed expanding a line of credit to the GSEs and, if necessary, taking an equity stake in them.
Congress is due to approve the lifeline this week. An implicit government guarantee of Fannie and Freddie will become explicit and taxpayers will foot the bill. As the former president of the Federal Reserve Bank of St Louis, William Poole, said, “essentially those companies are de facto nationalised”.
Leading US investor Jim Rogers expressed what many were thinking: “I don’t know where these guys get the audacity to take our money, taxpayer money, and buy stock in Fannie Mae. So we’re going to bail out everybody in the world. And it ruins the Federal Reserve’s balance sheet.” A fair enough reaction given that a government rescue of Fannie and Freddie might move the GSEs’ $US5trillion in liabilities on to the federal balance sheet, doubling US public debt and endangering America’s AAA credit rating.
But that only scratches the surface of what is wrong with a government bailout of Fannie and Freddie. No one talks about moral hazard much these days. That’s a shame. The principles remain compelling. Market failure is an integral part of the market. When the stock market punishes a poorly performing company, it’s a powerful message to other companies to lift their game or suffer the same fate. The fear of failure drives success. To be sure, it’s a tough deal for shareholders and employees when a company fails. But then the market deals in efficiency, not justice.
When a government bails out a company, it interferes with the market’s ability to punish corporate losers. It simply delays even greater pain. Left to its own devices, the market makes faster and better decisions than governments. Not perfect decisions. But better than those made by politicians.
None of this is to deny the need for sensible government regulation. And there is plenty of room for reform in the US where teaser rates of interest and other dubious practices such as limited-recourse loans built a sub-prime house of cards that led to “jingle mail” where borrowers simply sent the keys to their home to the bank. Advocating regulatory reform and believing in the market are not mutually exclusive.
The most powerful message from the woeful tale of Fannie and Freddie is that governments should be regulators, not speculators. They had no business being in the mortgage business in the first place. Treasury Secretary Henry Paulson told Congress last September: “If we knew then what we know now, we likely would not have designed entities like the GSEs that have private ownership but are required to undertake a public mission. These competing interests are too difficult to manage, and the potential long-term market distortions and public policy concerns are too significant.”
Fannie and Freddie were treated by US policymakers as special. They were allowed to keep less cash on hand and because they paid less to borrow money, they made more money from their mortgages. With their implicit government guarantee, fear of failure was not a factor. Mortgages flowed to those who did not have the means to support loans. Fine in a rising market when soaring profits went straight to shareholders and executives. With profits travelling to Congress as political donations, it was business as usual at Fannie and Freddie.
Alas, corporate socialism is a bipartisan affair in Washington. Neither Republicans nor Democrats dared reform the stockmarket darlings. Not even accounting scandals at Fannie Mae in 2003 or at Freddie Mac in 2004 convinced Congress to regulate the GSEs in the same way as their competitors. Lobbying efforts succeeded. Political donations were pocketed. Lax regulation fattened up Fannie and Freddie so they were too big to fail. Wiser minds warned that taxpayers would end up paying to save Fannie and Freddie. Washington’s political class did not listen.
Now, the Feds, the Bush administration and Congress have no choice but to rescue their own creations. Allowing Fannie and Freddie to crash would send shockwaves through markets worldwide, as the GSEs attracted investors across the globe, including central banks and superannuation funds. But the real question is whether US policymakers and regulators will finally agree that these institutions are, as The Wall Street Journal has said for years, just a dishonest form of socialism. Better to make them honest by taking them over, taking away their special status and then, over time, winding them up, thus closing the chapter on a failed experiment.
Fortunately, talk of creating an Aussie version of these semi-socialist creatures is only swimming around in obscure academic circles. But the fear is that if the economy dips even further, and the credit crunch tightens, more people will demand that the federal Labor Government “do something”. Doing this would be madness for the markets, and more importantly, costly for taxpayers. So ends the story of Fannie Mae and Freddie Mac.
source: http://blogs.theaustralian.news.com.au/ ... socialism/