Wayne Winegarden

Herbert Simon once remarked “"That which cannot continue forever – won’t." If only Secretary Paulson applied that wisdom to Fannie Mae and Freddie Mac (the GSEs).

The government chartered Fannie Mae in 1938 to increase homeownership and home affordability in response to the Great Depression. Freddie Mac came along over 30 years later in 1970. Fannie Mae and Freddie Mac are an excellent case study illustrating the consequences that arise when vague notions of “Corporate Social Responsibility” are combined with a for-profit business model. In the case of Fannie Mae and Freddie Mac, the consequences are diminished U.S. economic performance and increased overall financial risks.

The immediate problem prompting the latest financial bailout is the huge losses of the GSEs coupled with the size of their portfolio: together, both companies owned nearly $2 trillion in assets as of June 2008. Due to their mounting losses, the market was starving Fannie Mae and Freddie Mac of the capital necessary for the firms to stay solvent. The sheer size of the companies meant that their troubles were feeding into the already stressed mortgage market, leading to higher home mortgage interest rates. Fears mounted that the higher home mortgage rates were threatening the already strained financial system. These fears forced the Treasury into action.

The Treasury’s actions officially recognized that Fannie Mae and Freddie Mac are in fact insolvent; and, their regulator, the Federal Housing Finance Agency (FHFA), is now in control. Treasury Secretary Paulson’s program is designed to: ease the crisis at hand, preserve the assets of the GSEs, restore confidence in the Fannie and Freddie, mitigate the risks to the financial system, and try to minimize the ultimate cost to the U.S. taxpayer.

The Treasury’s plan does not address the larger systemic problems that helped to create the current mortgage market problems in the first place: the adverse economic incentives created by the current GSEs financial structure. Not linking the current solvency problem to the fundamental reforms necessary to prevent such crises from happening again squanders an opportunity to improve the workings of our financial system.

Wayne Winegarden

Wayne H. Winegarden Ph.D. is a partner in the firm Arduin, Laffer & Moore Econometrics.

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