Bailout a First Step

The Bush administration's bailout of Fannie Mae and Freddie Mac, the country's largest mortgage finance companies, is a potentially costly but absolutely necessary action to stabilize not only the U.S. housing market but also the broader world economy. Yet the bailout should be only the first step. The ultimate solution is to dissolve these two half-government, half-private entities, which have become dangerously obsolete mastodons in a globalized economy.

Together, Fannie and Freddie own about half of the country's home mortgages, an amount exceeding $5 trillion. Their sheer size and outsized impact on the economy alone warrant breaking them up and privatizing their holdings.

Both agencies were created as quasi-government instruments to promote homeownership. But the hybrid model had serious shortcomings. The principal one was that lenders and owners of Fannie's and Freddie's shares stood to reap the profits while taxpayers shouldered the risks.

Indeed, Fannie and Freddie ballooned out of control precisely because their mammoth operations greatly lessened the risks for other key players, primarily banks and mortgage companies. Here's how:

Fannie and Freddie bought up half of all the loans offered by banks and mortgage firms, on the notion that this would free lenders to offer even more loans, which indeed occurred. But when banks could be confident that Fannie and Freddie would soon take over their loans, banks were largely shielded from the risks of bad loans.

This spurred the subprime scandal and other unsound lending practices, such as "no docs" loans in which borrowers did not even have to document their income. Why should a banker worry about whether the borrowers could repay the loan if he was going to sell it at a profit within 90 days to Fannie or Freddie?

As the volume of bad loans escalated in recent months, the damage was intensified for Fannie and Freddie because they owned such a large share of the mortgage market. What's more, the damage quickly spread globally because foreign banks had purchased large amounts of the packaged loans sold by Fannie and Freddie. None of the big purchasers of Fannie's and Freddie's packaged loans had ever assessed the enormous risks posed by individual borrowers who recklessly took out gimmicky loans they could not repay.

In the end, the federal government had to step in and stem the losses, effectively making taxpayers ultimately responsible for the risks that should have been borne by the private sector. At least in the short term, the bailout appears to have brought stability to the panic-stricken housing market and given a boost to the stock market. Over the longer term, the government rescue should promote lower mortgage rates, further helping to bolster the housing market.

Under the bailout, Fannie's and Freddie's shareholders will receive no more dividends, and the value of their shares has plummeted to pennies. So, the shareholders also have shared belatedly in the bad risks of the past. Dissolving Fannie and Freddie would ensure that a mortgage fiasco on this scale will never be repeated.

REPRINTED FROM THE SAN DIEGO UNION-TRIBUNE.

DISTRIBUTED BY CREATORS SYNDICATE, INC.