The Unintended Consequences of the Fannie and Freddie Bailout

As of now, the Fannie and Freddie story is pretty well known, and has been looked at from a number of different angles (see various articles and posts here, here, here, and here). Now we find out that the auto industry is set to press Congress for $50 billion in low-interest auto loans (see CNN Money article). The government loans are expected to be used to help modernize plants and help the car companies make more fuel efficient vehicles. Congress had already authorized $25 billion in loans last year, but apparently that is now not enough. It is believed that the loans would have rates between 4-5 percent. Even though market rates are fairly low already, the credit ratings of both Ford and GM have fallen below investment grade, making it difficult to borrow anywhere near 5 percent.

This of course makes one wonder at which point all of this stops. Sure, it is important to keep Fannie and Freddie and the general housing mess from bringing down the financial markets, but at what cost? Starbucks has fallen on hard times. Should they get some type of bailout or support? What about Sears Holdings, with the struggling Sears and K-Mart retailers? Is it time for the airlines to go back to the well? The argument of course is usually attached to the financial sector, talking about things like contagion, or national interest, for industries such as defense and manufacturing. But where is the consistency? Just as loans are being requested to help build hybrids, electric cars, and other alternatives, other measures to increase low cost electricity or reduce our energy independence are met with resistance. Even more unsettling is that by choosing to bailout Fannie and Freddie, we (the taxpayers) are now all investors in the mortgage markets, whether we choose so or not. To add insult to injury, we can even lose more than our initial investment.

Of course the real issue of concern may not be whether or not a specific industry or company is receiving low interest loans or a nice government contract, or whether we are being forced to invest in risky companies against our will, but whether the trend of privatizing profits and socializing risk is really good for free markets. As readers know, I often discuss the need for risk management, but unfortunately for many companies their idea of risk management is simply letting the government take the reins when things go bad. Again, the point is not specifically about the current problems or plan proposed by Secretary Paulson. It appears that he had no other choice, and as he stated on CNBC: "played the hand he was dealt." Yet, should it have gotten to this point?

As is now obvious, banks kept making loans without worry of whether homeowners would pay them back. They could simply sell the loans off to Fannie and Freddie, sponsored in part by the government. While Fannie and Freddie were indeed "just" sponsored entities, there was always a "wink-wink" understanding that the government would step up in times of need. As such, both risk and return were adjusted accordingly. Yet, this was part of the problem. By having in place what amounted to a zero deductible insurance policy, Fannie and Freddie could go off and look for ways to juice returns by creating portfolios that really had no purpose other than to help meet quarterly numbers and make Wall Street and shareholders happy - all the while knowing that if things got bad, Uncle Sam was there to save the day. Well, that day has come, and now the government is left with few options, tax payers are left with more risks and unwanted investments, and the free-markets are a little less free. Where does it stop?