Monday, September 8, 2008

Should the Government Have Saved Fannie and Freddie?

Saving Fannie Mae and Freddie MacI'm sure you know what I'm going to answer about this before I answer it because you know how I feel about governments stepping in to "save" private businesses.  And of course, you would be right.  I really wish the government had not done anything here, since I really worry about moral hazard.  It also really bothers me that I'm sure the executives of these companies got rich and handsome bonuses based on taking on tremendous risk in the market.  They bought these high yield, high risk assets and made a killing for years.  I'm sure they had bonus structures tied to this performance.  Now that the bill comes due, they are off the hook because the government decided to bail them out.

But I digress for now.  What I really don't understand is what the government is trying to accomplish.  Do they think that by taking over these two failed institutions, they can somehow turn the tide of the housing market?  If they do, the government is even dumber than I thought because this will do nothing to help the average American who is struggling to pay their mortgage.

Let's think for a moment what caused the housing crisis in the first place. Put simply, it was a typical asset bubble.  Nothing more, nothing less.  People got caught up in the real estate myth that housing is the best investment you could ever have and that home prices never go down.  So people bought houses and kept buying houses despite souring cost because they feared being "priced out forever".  All this despite the fact that incomes were not keeping up with the skyrocketing mortgages.  When the music stopped playing, and the chairs were all taken away, we were left with a glut of houses.  Simple economics took over.  When supply starts to outstrip demand, prices fall.  This has caused the underlying value of all the mortgages to fall as well as the asset backing them is plummeting in value.

As these mortgages and derivatives start to lose value, it causes a ripple effect.  Nobody wants to buy an asset falling in price, causing there to be illiquidity in the market.  As nobody will buy these products, new ones can't be created either, meaning the financial markets freeze up.  This cascades even further and makes a system that feeds back on itself and creates even further price declines.

So given this, how will the bail out help?  The bail out has a net effect of ensuring that there is  more money made available to make mortgages.  This might have the effect of lowering interest rates which in turn could make mortgages more affordable.  But look back at what caused the problem in the first place.  Too many houses are out there for too few buyers.  The average income is not able to pay for the average mortgage.  Having more money available doesn't solve this problem.  Housing prices will fall until affordability comes back into line with incomes.

So who does it help?  Definitely not average joe American.  It does help a few institutional investors who have Fannie or Freddie debt.   It helps out the stock market in the short term, but it won't reverse the mid-term trend of the decline.  So we just spent upwards of $25 billion for what?  The short term benefit of a couple of wealthy investors?


  1. Like you said, the bailout is only a short term band-aid for a select few investors. Why the government feels the need to step in? Well, I have two theories: (1) these few investors are very influential and (2) the government wants to show the public that it is doing something.

  2. Hi Terrence

    So what do you say about the Fanny Mae stock? Might this be a buy since it is very low now? Or is it even more risky to buy it now? What is your opinion on those stocks?

  3. No! Stay away. The government, if they are smart, should wipe out all the equity for these institutions.

    Then again, that does assume the government is smart ...

  4. I wouldn't buy stocks of mortgage companies in the next 3 years.