The government subsidy to the GSEs allows them to raise funds at “below market” interest rates. Lower borrowing costs for Fannie and Freddie redirect resources away from other potential uses in the economy toward mortgages, raising the borrowing costs for other investments. Productive investments in other parts of the U.S. economy are, consequently, “crowded out” due to the favorable borrowing costs of Fannie Mae and Freddie Mac. Greater opportunities to fund emerging small businesses, increase economic efficiencies, or finance opportunities that people value more are subsequently lost.

The subsidy also creates adverse economic incentives for the GSEs themselves that compromises the efficiency of the mortgage market and violates the companies’ very raison d’être. The private shareholders of Fannie Mae and Freddie Mac reap the profits when their investment strategy makes money. But, when the strategy loses money, the government steps in and forces the taxpayer to share in the company’s losses. Consequently, the system provides the incentive and opportunity for individuals to profit from their risks but not suffer the consequences if these risks go bad. Under such circumstances, it should not be surprising that people take on more risk.

Perhaps more troubling, the government subsidy encourages Fannie Mae and Freddie Mac to continue injecting excess mortgage liquidity into the system despite signs that a real estate bubble may be forming – why give up the opportunity to make money when prices are rising if the government will cover your losses when prices are falling. Due to the adverse economic incentives, the GSEs increase the volatility of the mortgage market; and, helped to fuel the housing bubble currently plaguing the nation by continuing to flood the housing market with liquidity at precisely the wrong time.

The CSR justification behind our current Fannie Mae and Freddie Mac policy is flawed. Their special status skews our economy’s capital allocation process and raises the overall risk to our mortgage markets. Treasury’s plan should have begun the process of dismantling or privatizing both Fannie Mae and Freddie Mac. Instead, the plan is designed to remedy the crisis at hand and then punt on implementing reforms that would remedy the deeper adverse economic incentives exacerbating our current financial problems.

Because Treasury Secretary Paulson did not address the fundamental problems with Fannie Mae and Freddie Mac that helped to create the current financial problems in the first place, the country’s financial system remains vulnerable to the same problems in the future. More ominously, Fannie’s and Freddie’s business model provides a glimpse at the unintended and undesirable consequences that emerge from the current trend of companies implementing CSR-type policies.