Uncle Sam To The Rescue

The Treasury Department and the Federal Reserve rode to the rescue of Fannie Mae and Freddie Mac over the weekend, promising to lend freely to the giant mortgage companies and provide capital if necessary.

The government's goal was to fend off the kind of mass panic among lenders and customers that brought down Bear Stearns in March and IndyMac Bank last week. The federal promise seems to have done the trick, at least for the moment. Freddie found investors lined up as it auctioned off $3 billion in short-term debt on Monday.

It's never pleasant to see the government place the taxpayers' money on the line to save a private company. But in this case, the rescue appears to have been necessary. The alternative might have been chaos. The two companies combined own about half of the $12 trillion in U.S. mortgages.

Although privately owned, Fannie (the Federal National Mortgage Association) and Freddie (the Federal Home Loan Mortgage Corp.) were chartered by Congress decades ago to provide a secondary market for mortgages. When banks make mortgage loans, they usually sell them to Fannie or Freddie. The banks use the money from the sale to make more home loans.

Fannie and Freddie now buy two- thirds or more of all new mortgages in America. If the mortgage cousins were to fail, money for new mortgages would dry up. Home prices, already falling, would collapse. More homeowners would default. The homebuilding industry would crater.

Banks and other investors hold $1.3 trillion in securities issued or guaranteed by Fannie and Freddie. If the companies were to fail, the result might be a cascade of bank failures that would dry up credit and would guarantee a deep recession.

Although Fannie and Freddie are so-called "government-sponsored enterprises," the government does not explicitly back them.

But within the investment community, they are understood to be too big for the government to allow to fail. This weekend, with the solvency of both firms in question, the government reacted.

How much will this cost taxpayers? Perhaps nothing. The mere promise of a federal rescue should give big financial institutions the confidence to keep doing business with the two. The mortgage cousins may squeak by without a bailout.

The mess shows the need for much tighter federal regulation. The travails of Fannie and Freddie only indirectly stem from subprime mortgage disaster. Fannie and Freddie largely stayed out of that risky business. In fact, the definition of a subprime loan is one deemed too risky for Fannie or Freddie.

But subprime lending helped inflate the housing price bubble. When the bubble popped, defaults began rising, even on better-quality mortgages. That's where Fannie and Freddie got in trouble.

Still, the cousins wouldn't be in trouble if they'd kept adequate capital, a cushion of owners' money kept on hand to absorb losses. Regulators allowed Fannie and Freddie to skate by with small cushions.

Fannie is known for masterful lobbying and deft distribution of political contributions. Its success in warding off regulation led directly to its current dire straights.

Treasury Secretary Henry Paulson wants authority to buy stock in Fannie and Freddie as a means of injecting capital into the companies. Paulson reportedly is insisting that the companies' shareholders be wiped out if a bailout becomes necessary.

Good for him. Fannie and Freddie are odd ducks in American business. Their profits go to private shareholders, but their losses can fall on the taxpayer. That can encourage risky behavior. So it's important that shareholders suffer the consequences if risks go bad.

If a bailout becomes necessary, Paulson should insist on appointing a majority of directors at Fannie and Freddie. Whoever pays the bills should call the shots; Fannie and Freddie may need a housecleaning in their executive suites.

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