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Commentary: To fix Fannie and Freddie remove the moral hazard

This article first appeared in the St. Louis Beacon: July 18, 2008 - It is the surprising incident that gets you. The unseen car that nearly hits you when crossing the street. The bolt of lighting out of the blue. But while the surprising magnitude of the mortgage market collapse exacerbated problems for Fannie Mae and Freddie Mac, the mess wasn't completely unexpected.

William Poole, then president of the St. Louis Fed, churned financial markets in 2003 by stating that the two mortgage giants lacked adequate capitalization. In the event of the unpredictable shock, both lacked enough cushion to cover potential losses. Recently, Poole suggested that by normal accounting standards they are insolvent: The value of their assets isn't enough to cover the liabilities.

If Fannie and Freddie were private corporations, they'd have already filed for bankruptcy protection. But they are not. They are government-sponsored enterprises, or GSEs. And that is the problem.

A GSE is owned by shareholders with implicit backing by the government. Profits accrue to stockholders in good times; losses are borne by taxpayers in bad. This arrangement promotes moral hazard, which, as the names suggests, is not good.

Moral hazard occurs when managers of a firm have nothing to lose by gambling on the big return. If they win, they look like financial wizards. If they fail, the government steps in and covers their losses.

This happened during the lead-up to the S&L meltdown of the 1980s.

With FSLIC insurance covering deposit liabilities, S&L managers gambled on the real estate boom and lost. When it was over, that cleanup cost taxpayers more than $100 billion.

Even though the backing of Fannie and Freddie is only implicit, markets know that, once trouble arises, the government cannot let them fail. As they say, these two mortgage giants are just too big to fail. But given this implicit guarantee, why did their stock prices tank?

Because no one really knows how creditors' claims would be settled if they "fail," people dumped their stock. The uncertainty arises because there is no established mechanism to handle the insolvency of a GSE. This, says Fordham law professor Richard Carnell, increases the "uncertainty about the priority and process for handling creditors' claims [and] could worsen the firm's problems." In the event of troubles, this uncertainty would likely roil financial markets and lead to a costly government bailout.

Is the solution to increase their capitalization?

Poole's suggestion is fine after the fact, but it confuses the quasi-public nature of these organizations. Requiring them to hold a higher percentage of capital could reduce their profitability and hamper their ability to raise funds.

What about increased regulation?

Congress has a poor track record when it tries to quickly passing new regulation to prevent repetition of what has already occurred. New regulations instituted on the heels of the 1987 stock market crash did little to prevent the market's troubles in 2000. Sarbanes-Oxley, passed to prevent another Enron debacle, resulted in a paperwork nightmare for firms. Neither staved off the current problems.

In all likelihood, the government will cover any losses that Fannie and Freddie incur. This will take the form of the government infusing capital by purchasing the GSEs debt and by allowing them to borrow from the Fed.

Fannie and Freddie's current regulator, the Office of Federal Housing Enterprise Oversight will lose its oversight of these corporations and a new regulatory body will be created. This resonates with a growing number in Congress who, in an election year, have become increasingly willing to voice their skepticism of free market capitalism.

Until the basic moral hazard problems of GSEs like Fannie and Freddie are dealt with, however, quick-fix regulatory changes are more likely to increase the costs of dealing with the next financial crisis.

R.W. Hafer is research professor and chair of the department of economics and finance and director of the Office of Economic Education and Business Research at Southern Illinois University, Edardsville. 

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