Thursday, July 10, 2008

The case for private and against government solutions: Fannie Mae & Freddie Mac

Markets fail, as do institutions in the private sector. However, public sector solutions are much bigger disasters:

What Americans need to know is how damaging such a failure would be. This wouldn't merely be a matter of the Federal Reserve guaranteeing $29 billion in dodgy mortgage paper, a la Bear Stearns. Fannie and Freddie are among the largest financial companies in the world. Their liabilities – mortgage-backed securities (MBSs) and other debt – add up to some $5 trillion.

To put that in perspective, consider that total U.S. federal debt is about $9.5 trillion, compared to a total U.S. GDP of $14 trillion. About $5.3 trillion of that debt is held by the public (in the form of Treasury bonds and the like), while $4.2 trillion is intragovernment debt such as Social Security IOUs. This is the liability side of America's federal balance sheet, and its condition influences how much the government can borrow and at what rates.

The liabilities of Fan and Fred are currently not on this U.S. balance sheet. But one danger is a run on the debt of either company, putting pressure on the Treasury and Federal Reserve to publicly guarantee that debt to prevent a systemic financial collapse. In an instant, what has long been an implicit taxpayer guarantee for both companies would be made explicit – committing American taxpayers to honoring as much as $5 trillion in new liabilities. U.S. debt held by the public would more than double, and the national balance sheet would look very ugly.

Why is there so little Washington or Wall Street alarm about this? Because the politicians and financiers are part of the consensus that has long promoted the growth of Fannie and Freddie. Congress created the companies to spur home ownership and, in return, got an endless stream of campaign contributions and election support. Beltway elites like James Johnson and Jamie Gorelick made tens of millions working there. Wall Street marketed their MBSs to buyers around the world, pitching them as virtually as safe as Treasurys (due to the implicit taxpayer guarantee) but with a higher return. Everybody made a bundle.

The assumption was that the taxpayer guarantee would never have to be honored, just as everyone before the savings and loan debacle thought deposit insurance would rarely have to be paid. But these political bills always come due.

The double irony amid the current credit crunch is that our politicians have been promoting Fannie and Freddie as mortgage saviors even as their risk of insolvency has grown. Chuck Schumer, Chris Dodd and many others have encouraged the duo to take on even greater mortgage risk as the housing slump has unfolded. They're the arsonists posing as firemen while putting more dry tinder around the blaze.

My addendum to this is, why do we have LESS transparency with government agencies in regards to their balance sheets and revenue activities than public corporations, when it should be the opposite?!?

UPDATE: More from Arnold.

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