What To Do With Fannie and Freddie? (Updated)

William Poole and Lawrence Summers seem to have different ideas about how the problems with the public/private mortgage giants should be dealt with. In the New York Times yesterday former Federal Reserve Bank president William Poole proposed that the two chimeras first be bailed out, then gradually dissolved:

The long-term health of the mortgage market is too important to be left to only two firms. If Fannie Mae and Freddie Mac can survive as vigorous competitors without the special government privileges they’ve long enjoyed, fine. But if they insist on coming back to life as public-private hybrids with all sorts of unfair federal advantages, we’ll only be setting ourselves up for more disasters. The wisest move, in the end, is to carefully let them wither away.

Economist (and former U. S. Secretary of the Treasury) Lawrence Summers, writing in the Financial Times has a slightly different prescription—the institutions should be bailed out, then re-structured:

In this scenario, the government would operate the GSEs as public corporations for several years. They would then be in a position to extend credit where appropriate to support resolution of the current housing crisis. Once the crisis has passed, the federal government would divide their functions into government and private components, the latter of which would be sold off in multiple pieces. The proceeds could be used to fund the low-income housing support activity that was previously mandated to the GSEs.

With this approach, the federal government would be in a position to support the housing market in the years ahead without encouraging dubious financial practices or denying financial reality, as is the case today. In the longer term, it would provide an opportunity to rebuild the housing finance system on far stronger foundations.

I think that my views are more in synch with Dr. Summers’s. As I understand it the original purpose of the older institution, Fannie Mae, was to ensure continued liquidity in the mortgage market. Unless a compelling case can be made that the structure of the financial market, sans Fannie Mae and Freddie Mac, has changed sufficiently to preserve that function it would seem to me that it would still be necessary and we’d dissolve Fannie Mae only to reconstitute in a different form. Perhaps some better informed person than I can comment on this.

I wholeheartedly agree with this portion of Dr. Summers’s comments:

Consider how much more problematic the Bear Stearns response would have been had policymakers signalled their commitment to back the company’s liabilities without limit; left management in place with no change in the business model; and allowed dividends to be paid and shareholders to keep going with hope for a better tomorrow. Yet all of these elements are present in the cases of Fannie and Freddie.

I see no reason to preserve shareholders’ equity while bailing Fanne Mae and Freddie Mac out. If they’re going to take the rewards, they need to be willing to absorb the risks, too, and that hasn’t been the case.

Update

Paul Krugman has put in his two cents on the subject today:

The desperate rescue efforts of the past year make expanded regulation even more urgent. If the government is going to stand behind financial institutions, those institutions had better be carefully regulated — because otherwise the game of heads I win, tails you lose will be played more furiously than ever, at taxpayers’ expense.

Of course, proponents of expanded regulation, no matter how compelling their arguments, will have to contend with very well-financed opposition from the financial industry. And as Upton Sinclair pointed out, it’s hard to get a man to understand something when his salary — or, we might add, his campaign war chest — depends on his not understanding it.

I sincerely wish Dr. Krugman would devote some of his considerable abilities to updating our financial framework “to 21st-century conditions&#148, as he puts it. Specifically, I’m curious about how regulating overseas institutions over whom the U. S. government has little influence would work out or, contrariwise, how allowing overseas operators who aren’t subject to U. S. regulation on their home turf to compete with our domestic institutions who are, even if the overseas institutions are required to abide by our regulations when operating here. Sounds like a formula for making U. S. banks non-competitive to me.

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