The GSE Question

Somewhat related to previous horrible economics post (I’m really not proud of that one, though I do love to see the always-expressive Frank Costanza), there’s been a question that has been bugging me about Fannie Mae and Freddie Mac ever since their solvency came into question.

The way I see it, Fannie and Freddie didn’t get into trouble entirely because of poor management on the private side, but had a lot of help from the governmental push to have them pick up the slack when the private sector began to fail (as well as the strange “Homeownership Society” soft pressure that I assume was applied to their underwriting processes).

The way I see it, the federal government helped to put Fannie/Freddie in the situation they’re in now, and that adds further obligation to make their implied backing of the GSEs explicit.

However, I am very curious why Fannie and Freddie can’t be allowed to fail?  (This question is largely answered by Bob Morris from Polizeros in his comment on my previous post) The interconnectedness certainly adds a tremendous element of unpredictability in outcome, however the only other reasoning I’ve heard is that with liquidity as limited as it is, Fannie and Freddie are the only game in town.  I can understand the importance for THE FUNCTION served by the GSEs, but that second argument doesn’t make me believe that the entities themselves, Fannie and Freddie, are essential to the function.

It seems like the original sin may have been the implied support from the federal government to begin with that makes the GSE Question so muddled.  Bondholders have been earning higher returns on GSE debt over treasury debt, despite that the government’s backing was only implied (albeit now fairly explicit).

So let’s start over:  Let’s allow Fannie and Freddie to fail, and let’s stop with the wink-wink economic manipulation and pick a side.  Either let the free market take care of it, and let a private entity fill the appealing gaps left by Fannie/Freddie (I recall reading — likely at Calculated Risk, Naked Capitalism, or Mish’s Global Economic Trend Analysis — that much of Fannie/Freddie’s busines has been concentrated in the safest and most desirable securities since the onset of the crisis… can anyone confirm?)…

… OR: Create a government entity that performs their function with a straight face.  Not a GSE, but a plain-old GE.  No wink-wink about federal backing and no whip-cream-on-top extra yield.  If taxpayers are picking up the tab, at least they should know it.

I understand that this does not address the issue of interconnectedness at all (nothing I can think of does, and every ‘major’ institution’s viability can easily be made into a case of systemic life or death and can never be verified), but is this otherwise a practical solution?

… and the cow goes moo