The Perils of Paulson

By Vincent Reinhart
Tuesday, July 15, 2008

The chief stewards of U.S. financial market policies seem to be living out an old-time movie serial. Over the past year, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have moved from crisis to crisis, improvising as they go. The distressed damsels they saved over the weekend were the government-sponsored mortgage giants Fannie Mae and Freddie Mac.

Part of creative policymaking, as in moviemaking, is obscuring the moving parts. But it's clear even now that over the weekend the government safety net was significantly expanded, the lines between the public and private sector were further blurred, and the odds were raised that such government rescues will be needed in the future.

Fannie and Freddie, as government-sponsored enterprises, are public-private entities with special advantages to foster housing finance. Those advantages include a backup line of credit with the Treasury, exemption from some securities registration requirements and the designation of their debt as "government securities." The whole package combines to confer a huge perk: Investors believe that the firms' debt is implicitly guaranteed by the government. Thus the debt that Fannie and Freddie sell commands a yield close to those on Treasury securities, and they need not hold as much capital as other firms are required to. This gives them a significant leg up on their competitors.

Investors have recently become concerned about what would happen if the implicit guarantee were tested. If markets turned against Fannie and Freddie, would all securities be backstopped by the government? Would the interests of existing shareholders be diluted? As worries have spread, Fannie and Freddie's reception in funding markets has chilled and their share prices have plummeted.

These concerns set policymakers in motion. The government has essentially built two bridges for these institutions. In the very near term, the Federal Reserve has granted them access to its discount window.

The Fed bridge is set to shut down when the Treasury link opens. This requires Congress to expand the Treasury's authority to lend and to allow the purchase of preferred stock. The Treasury would be providing longer-term funding, presumably giving the entities time to shore up their balance sheets by raising more capital.

The argument is that if the government opens its checkbook to these firms, private investors will be less likely to flee.

Indeed, if investors become sufficiently confident, the crisis could fade without the government's lines being tapped at all.

Yet there are two reasons to doubt that this movie ends so happily and two reasons to wish it were never made.

First, in the near term, continued double-digit declines in housing prices will raise doubts about the repayment prospects of more and more mortgages. Add to that the difficulties associated with an economy teetering on the brink of recession. Anyone holding mortgages or mortgage-related securities is in for a bumpy ride. Fannie and Freddie, which are exposed to more than half the market, are sure to face large losses and squalls of investor uncertainty.

Thus the second problem: The endgame is uncertain. The government's funding responsibility will end only when the two firms have raised sufficient capital. It will be impossible for the Fed or the Treasury to turn away a request for more credit. The overall provision of credit could, therefore, be sizable and extended.

While policymakers have at least temporarily resolved this crisis, we will live with the consequences for a long time. Consider the downsides:

First, the Federal Reserve is likely to be given additional responsibilities related to overseeing housing finance. What happens when that goal interferes with the ones Congress has already given it -- fostering maximum employment and stable prices? An overextended Fed might be tempted to keep the liquidity tap open too long to support housing finance, even at the cost of a pickup in inflation.

Second, the government had to act because, in today's interconnected markets, Fannie and Freddie are too big to be allowed to fail. Policymakers missed an opportunity for significant reform.

The public-private mix embodied in the GSEs has been shown once again not to work. The public aspect lulls investors into complacency, while the firms' private management will always try to keep their capital reserves as low as possible, potentially endangering the companies' solvency.

Policymakers could have used the crisis to focus attention on the entities' appropriate long-term status. The government could have privatized them completely by severing the implicit guarantee or nationalized them by allowing their equity to go to zero, as the market was headed. (My preference is the former, but even the latter has advantages over what policymakers did.) Instead, our nation is now reaffirming a model that does not work, almost guaranteeing a repetition of this problem down the road.

The writer, a former director of the Federal Reserve's division of monetary affairs, is a resident scholar at the American Enterprise Institute.

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