The Case for Wiping out Fannie/Freddie Shareholders

Peter Wallison at AEI has a missive out applauding the government’s move in supporting Freddie/Fannie, but scolding them for fuzziness about their equity purchase plans. If/when they decide to purchase shares they need to wipe out Freddie/Fannie shareholders — or risk bigger losses down the road.

Here is Peter:

The Treasury’s formal recognition of the government’s responsibility for Fannie Mae and Freddie Mac is an important and essential step forward. No other position was possible in current conditions. The market reaction shows that Treasury secretary Henry Paulson’s statement had the desired effect: the market is now convinced that the U.S. government stands behind Fannie and Freddie.

The proposal to purchase an equity position in either Fannie or Freddie, however, would be a mistake unless their existing shareholders are wiped out and the government takes full control of their management. Allowing the continued operation of the companies as private, shareholder-owned institutions, while the taxpayers are ultimately responsible for their losses, recapitulates our experience with the savings and loans less than twenty years ago. In that case, forbearance in closing them down when they were insolvent, or nearly so, allowed them to “gamble for resurrection,” ultimately increasing the losses that the taxpayers were required to shoulder. The same result can be expected if Fannie and Freddie are allowed to operate indefinitely with government capitalization. Regulation alone has never been able to prevent this risk-taking.

The same problem is present when and if the government lends to Fannie Mae and Freddie Mac without assuming control of their operations. Again, government support allows them to continue taking risks, which will only increase the losses when the taxpayers ultimately have to meet their obligations and close them down. Nevertheless, a substantial line of credit for Fannie and Freddie at the Treasury would be necessary to meet their obligations as they come due, while their operations are reformed or wound down. Their assets cannot be sold in amounts necessary to meet these obligations without putting further downward pressure on already stressed housing and mortgage markets.

Finally, the proposal to open the Fed’s discount window to Fannie and Freddie makes no sense at all unless they cannot raise funds in the credit markets. The capital markets have always believed that Fannie and Freddie were backed by the U.S. government, and the recent moves by Treasury confirm the validity of that view. In that case, both government-sponsored enterprises should be able to raise funds in the credit markets at lower rates and in larger amounts than they could borrow from the Federal Reserve, and without collateral. If the credit markets are now unwilling to lend freely to Fannie and Freddie, however, there is no choice but to enact legislation that will enable them to be taken over by a receiver. Borrowing from the Fed can only be an interim step in that direction.