Capital Commentary is the weekly current-affairs publication of CPJ, written to encourage the pursuit of public justice.

The Fannie-Freddie Bail Out

James Skillen


August 1, 2008

In the face of continuing economic stresses, most of them tied in one way or another to housing-finance difficulties, Congress and the Treasury department worked hard for weeks to come up with a complex bill to guarantee the mortgage creditworthiness of two government-sponsored enterprises (GSEs) popularly known as Fannie Mae and Freddie Mac. President Bush, who earlier threatened to veto the bill, signed it into law on Wednesday.

The new law’s central purpose is to forestall a collapse of the two GSEs, which are the largest holders of US home mortgages. They currently guarantee about $5 trillion worth of mortgages. Given the serious decline in home values over the last year, investments in the two GSEs have declined. Under ordinary market conditions, they could easily go bankrupt. If that happened, the US would experience a financial crisis of immense proportions.

The immensity of the problem may be difficult for us non-economists to grasp. If the federal government literally had to take on that full debt burden, it would add $5 trillion to its already immense $9-plus trillion debt. Hoping nothing that terrible will happen, Congress and the president nonetheless anticipated growing federal indebtedness and raised the federal debt limit to $10.6 trillion.

If that were not enough, we need to recognize that a huge amount of the investment in Fannie Mae and Freddie Mac is from foreigners, whose money (and confidence) our economy needs to keep going. On Tuesday it was reported that the Russians, who had $100 billion invested in Fannie and Freddie at the start of the year have since reduced that investment by half (Financial Times, 7/29/08). In other words, the combination of declining home values and home sales with the withdrawal of investments in the two GSEs threatens a monumental disaster.

Something had to be done, of course, but given the intricacy of economic dynamics, we should not be overly critical if our government’s response in this case is inadequate or even mistaken.

The debate among professional economists shows that this “necessary” bail out is not very satisfying on principled grounds. On the one hand, there are the Kudlow & Company folks who strongly object to the government’s interference in the marketplace. Government cannot fix this problem, they argue, and should leave it to market forces. The bail out is just another example of government overreach.

Critics on the other side say it was government’s failure to adequately regulate Fannie Mae and Freddie Mac in the first place that led to this crisis. What the government is now doing is simply placing the burden of market and regulatory failures on the backs of its citizens who will have to foot the bill. That is unjust. As Lawrence Summers puts it, the government allowed private investors to take the profits when things were going well and now it is socializing the losses (Financial Times, 7/28/08).

To my untrained eye, the situation looks like this. Americans believe so much in the free market that we approve of government keeping its hands off as long as the economy is growing and we are experiencing personal gains. But when things go bad, our only recourse is to government’s emergency action to try to keep the market from collapsing. We, the public, then become the bail-out team for the market’s investors who must be assured of a profit so they’ll stick with us. The pattern is as Summers describes it.

What we need instead is for government to focus on upholding justice for the entire Republic rather than to gamble with debt-accumulating economic stimuli to try to promote growth. Public justice requires adequate regulation of all market functions that could jeopardize society when the economy falters. Private investment failures should fall on investors and insurers, not on taxpayers who are dragged in after private losses threaten public stability.

— James W. Skillen, President
     Center for Public Justice

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Capital Commentary is a weekly current-affairs publication of the Center for Public Justice. Published since 1996, it is written to encourage the pursuit of justice. Commentaries do not necessarily represent an official position of the Center for Public Justice but are intended to help advance discussion. Articles, with attribution, may be republished according to our publishing guidelines.”