The problem lies in how Fannie Mae and Freddie Mac were created. They are Government Sponsored Enterprises.
The word "sponsored" is key. It means the companies could operate for all the world as if they were private for-profit companies, but they always carried with them the implicit understanding that, should anything go awry, the government would be there to bail them out.
And that brings us to today.
Over the weekend, Treasury Secretary Henry Paulson decided the two mortgage giants should be bailed out, or "socialized," as some would say (with good reason). He really had little choice. Without the government taking over, the two companies would have failed, and that would have created havoc in mortgage markets worldwide. Not only do the two companies underwrite about half of the mortgages in the United States, their bonds had been sold to many foreign investors. Had they simply gone under, the blow to the U.S. economy, and to faith in the dollar and the U.S. government, would have been hard.
But that doesn't mean the takeover is a good thing. It's especially bad for U.S. taxpayers, which includes just about everyone who will read this. You will be on the hook for perhaps as much as $5 trillion in mortgage-backed securities. That will have its own effect on the struggling economy.
The government, and especially Congress, bears a great deal of responsibility for letting things get to where they are today. Both companies were skilled at lobbying, with all that implies. With that kind of relationship with power, they rose to their present prominence, a level at which they became too important to fail.
But markets operate with brutal honesty, especially when governments try to intervene. The implicit guarantee that the government would keep Fannie and Freddie from foundering emboldened everyone involved to take unsafe risks. That has now led to a huge problem for the economy and a rather embarrassing bailout by an administration that was supposed to be dedicated to the free market.
Unless both companies are drastically restructured, the risks going forward are even greater. The government no longer has an implicit guarantee to bail Fannie and Freddie out, it has an explicit one based on precedent. That is an even greater invitation to risky behavior.
In announcing the takeover, Paulson said neither company henceforth would be allowed to lobby or participate in government activities. Both also would have to reduce their role in mortgage markets each year for the next decade.
We suggest going further. Privatize both companies. The next best thing would be to shrink and tightly control them, but even that would encourage some level of market risk.