Freddie Mac, Fannie Mae: Morality Tale

By Reuters -  |  Posted 2008-07-14 Email Print this article Print

U.S. regulators and politicians are doing whatever it takes to shore up Fannie Mae and Freddie Mac. A new plan allows for more government loans and options for regulators to buy certain securities to increase their capital.


However, the size and implicit government guarantee of these two financial giants introduces what economists call "moral hazard", the temptation that investors face to take excessive risk knowing that the government will eventually bail them out if things go wrong.

It was only four months ago, just before St. Patrick's Day, that the Fed, in an emergency move, backed and engineered JPMorgan Chase & Co's buyout of the failing investment bank Bear Stearns, which encountered funding problems as its mortgage securities holdings lost value.

Wallison and others warn that now is the time to start moving away from moral hazards like this, and they question why regulators and lawmakers haven't acted sooner.

"Both the Federal Reserve and the administration, for the longest time, sent signals that basically made them seem as if they were out of touch," said economist Christian Weller with the Center for American Progress, a liberal think tank here in Washington.

"It doesn't sound like market discipline at all," Weller said.

In fact, at a time when banks and Wall Street were setting aside more capital to cover losses in the fast-deteriorating mortgage markets, the Bush administration was unleashing Fannie and Freddie to lend even more.

The Office of Federal Housing Enterprise Oversight (OFHEO), a unit of the U.S. Department of Housing and Urban Development, or HUD, is part of the administration, not an independent agency like the Federal Reserve or the Securities and Exchange Commission. Politics, not taxpayer safety, drove its capital requirements for Fannie Mae and Freddie Mac, experts say.

"Reducing capital requirements was clearly a response to political pressure and not good regulatory oversight," said Gerald O'Driscoll, a senior fellow at the CATO Institute, a libertarian think tank, in Washington.

Fannie Mae and Freddie Mac shares have tumbled on worries that the falling value of mortgages they own or guarantee will burn up their capital, placing the fragile U.S. economy at even greater risk.

On Friday, the three major U.S. stock indexes sank about 2.0 percent by midday on escalating fears about the stability of Fannie Mae and Freddie Mac. By the close, the three indexes ended down about 1.0 percent.

Those concerns drove Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, and others to work throughout the weekend on a plan to keep these giants afloat.

"We must take steps to address the current situation as we move to a stronger regulatory structure," U.S. Treasury Secretary Henry Paulson said in a statement outlining steps to back Fannie Mae and Freddie Mac.


Amid all the financial turmoil brought on by the housing and subprime mortgage crisis, Paulson and other administration officials have called for regulatory reforms that would essentially put the onus on the Federal Reserve to lend to and oversee not just commercial banks, but investment banks and hedge funds.

Many experts question if this, too, is a risky move that could lead to more of a moral hazard.

"Getting everyone under one regulator is not the solution," O'Driscoll said. "The Fed had all the regulatory power it needed if had wanted to at least prevent the severity of the crisis."

(Reporting By Joanne Morrison; Editing by Jan Paschal)


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