Uncle Sam Goes Up the Hill After Fannie and Freddie Fall Down

Business News

July 10, 2008

By Senior Staff Editor, Corey May

Will Uncle Sam Go Up the Hill after Fannie and Freddie Fall Down?

It appears that the two governments sponsored housing markets, Fannie Mae and Freddie Mac, are taking a tumble. Fannie fell 13.8% on Thursday and Freddie dropped 22.0%. Although these government created organizations have shareholders, the government does not guarantee their sponsorship. It appears that Fannie and Freddie have fallen, but it also appears that the government will take them up the hill.

It is speculated that if Fannie and Freddie reach a point of undercapitalization, the government will step in. Quoting Senator Charles Schumer, (D-NY), "Fannie Mae and Freddie Mac are too important to go under and these markets should be assured that the federal government will stand by them.”

However, appearing before the House Financial Services Committee with Federal Reserve Chairman, Ben Bernake, Treasury Secretary Hank Paulson told Congress that the regulator of Fannie and Freddie have made it clear that they are properly capitalized. This only after Paulson was bombarded with questions about backing big financial institutions, but leaving Freddie Mac and Fannie Mae exposed. This was perhaps to calm an anxious and already stressed crisis in the housing market.

At one point a while ago, Paulson stated that the government would not bail out Freddie Mac and Fannie Mae. Nevertheless, it is widely perceived that Uncle Sam will bail them out should mortgage defaults force them to pay off bondholders whose debt they guarantee.

If there is a bail out it would be similar to the Bear Stearns bail out, where a company was left solvent, but investors got next to nothing. Paulson explained that the problem is not necessarily the size of the institution, but that the threat is really the amount of risk it takes on. It seems this to be relevant to the infrastructure, but how does the collapse of ABC Bank even compare to the collapse of Freddie Mac and Fannie Mae? The “size” comment left many shrugging and rationalizing that if the pillar financial institutions are permitted to fail, what happens to investor confidence? The government has already lowered their capital surplus by more than 30% to provide cash influx to the mortgage-backed securities market. Paulson’s attempt to massage the fear only spread an already contagious contemplation; the government will bail out Freddie and Fannie.

The bottom line, yet to be answered, is if an institution may be too big to permit failure, while in the spirit of capitalism we allow small institutions to fail. It is estimated that currently over 250,000 banks for sale in the US. Mr. Bernanke said that while current efforts were being concentrated on steadying the state of the US economy, it was not too early to consider measures to ensure the "orderly" liquidation of finance firms on the verge of bankruptcy in the future.

"For market discipline to effectively constrain risk, financial institutions must be allowed to fail," Paulson said Thursday. "Today two concerns underpin expectations of regulatory intervention to prevent a failure. They are that an institution may be too interconnected to fail or too big to fail."

It seems likely that new legislation will follow concerning the issue of when to liquidate and when the government should step in. The Federal Reserve already has such a policy in place for banks, but not other types of financial institutions. Many legislators claim that the crux of capitalism only works when it allows a rubber band to snap after it has been stretched too far.

Many who live on the other side of the street have a differing opinion. If Freddie and Fannie fall down and the government does not pick them up and take a recovery hike up the hill, many say that it will ruin the mortgage and housing business.