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Commentary By Nicole Gelinas

Uncle Sam Can Bail Out Fannie, But Who'll Bail Out Uncle Sam?

The taxpayers' predicament when it comes to Fannie Mae and Freddie Mac, the precariously capitalized "government sponsored" mortgage investors and insurers that own or guarantee $5.4 trillion worth of mortgages, or half the nation's total, is grave enough.

Graver still is that the rest of the world of supposedly high finance is becoming more like Fannie and Freddie, with potentially disastrous consequences for the American economy and taxpayer.

Everyone has long thought that Fannie and Freddie are too big to fail. The feds would never let them fall into bankruptcy because they're crucial to the nation's mortgage markets and broader financial markets. The two have used their government coddling to wrap themselves in a web of guarantees, insurance contracts and derivatives that makes Bear Stearns' business look as straightforward as a lemonade stand.

The mortgage disaster such a bankruptcy would create would mean near-certain depression. The Bush administration's move last week to ask Congress to let the federal government step in and buy shares of the two companies as well as lend up to $300 billion to them, along with the Fed's decision to let them borrow directly from the central bank, bears out this stark reality.

How did we get into this situation? It's useful to follow the reasoning behind the New Dealers who created Fannie's predecessor, the Federal Home Loan Mortgage Association, to see how the best of government intentions can be perverted by voracious market appetites and vice versa when government and business grow too cozy in pursuit of a reasonable-seeming goal—ending cyclicality in the mortgage markets.

In the 1930s, private lending for most activities, including home building and buying, had pretty much stopped. That was partly because banks had loaned heavily against stock-market and real-estate securities in the '20s and had no money left to lend once the value of that collateral evaporated.

Said John Fahey, Federal Home Loan Bank chairman, in 1938: "Overspeculation in real estate" proved "as dangerous to the general welfare as overspeculation in securities."

The solution was a new federal home-loan agency that would, in the words of the National Association of Real Estate Boards' finance chairman, Edward MacDougall, provide "a balance wheel." The lender "wants stabilized practice as the best assurance of the safety of his loan," while the borrower "wants assurance against getting caught in any such dearth of mortgage funds as was experienced in recent years."

The parent of today's Fannie Mae was born—"a better and sounder mortgage structure is being built out of the experience of past mortgage difficulties," the New York Times reported.

Fast-forward 70 years. Even though Fannie and Freddie are theoretically private companies, the taxpayer faces the worst of both worlds. The implicit government backing of Fannie and Freddie made all mortgages seem safer than they were; private-sector speculation over the past decade infected Fannie and Freddie's government-supported mortgage market with huge risk.

How? The worst excesses of the mortgage industry over the past decade weren't directly abetted by Fannie and Freddie, which didn't lead the way in risky loans like interest-only and adjustable-rate mortgages.

Part of the reason lazy private investors were so happy to lend to customers of Countrywide and IndyMac—two major lenders whose exotic mortgages weren't, for the most part, guaranteed by Fannie or Freddie—was that the long history of largely government-backed mortgage bonds lulled them into thinking all mortgages were safe.

On July 11, the FDIC took over IndyMac, a huge California bank that specialized in non-agency mortgages, while Bank of America's purchase of Countrywide likely saved the feds from the same fate there.

Even though most of Fannie and Freddie's loans didn't seem very risky, the collateral that backs them—homes—was bloated by the asset speculation fueled largely in the private markets.

Today Fannie and Freddie, and thus taxpayers, face the risk that as property values fall, even borrowers of the 30-year, fixed-rate mortgages that Fannie and Freddie guarantee will walk away from assets that aren't worth anywhere near what those homeowners owe on them.

Because Fannie and Freddie operate on such razor-thin margins, only a relative few have to make this decision to plunge the companies into catastrophe.

This freeze would be a disaster, at least in the short term. Since the credit crisis began and lenders have fled exotic mortgages, Fannie and Freddie have guaranteed three-quarters of new mortgages. If they slow or stop doing business, almost nobody will be able to get a mortgage, quickening the housing death spiral we're in.

So the government has put the taxpayer in an unenviable position. If home prices continue to fall, the government's explicit backing of Fannie and Freddie, into the trillions, imperils the sterling credit rating of the Treasury itself. That exacerbates the stress of looming obligations for baby boomers' Social Security and Medicare benefits.

If Fannie and Freddie were isolated cases, the situation would be bad enough.

But the squeeze gets worse. The government has spent the past six months creating mini-Fannies and mini-Freddies out of the nation's risk-taking investment banks.

The Fed's engineering of the Bear Stearns bailout—and its decision to let surviving investment banks borrow from the Fed, a privilege previously reserved for tightly regulated commercial banks—showed everyone that Uncle Sam won't let a big investment bank go bankrupt, just as he won't abandon Fannie and Freddie.

The federal guarantee means bondholders have to worry less. Firms have even less private-sector oversight of the risks they take on, again, just as with Fred and Fan.

As for the idea that better regulation of investment banks can cut this new risk for taxpayers: Fannie and Freddie have long supported employed armies of Washington regulators. They didn't stop the current meltdown. They contributed it to it by making the government-coddled mortgage industry seem insulated from speculation.

Fannie and Freddie artfully captured their regulators long ago, seducing the regulators into allowing tiny capital margins and highly concentrated risk. Does anyone doubt that the investment banks, with immense wealth and knowledge, can't do the same?

The Fannie and Freddie treatment of the investment banks, and the attendant government regulation, will make investment risk-taking seem, but certainly not be, risk-free.

Meanwhile, riskier-still activity will escape this regulation, moving even more heavily into hedge funds and the next new thing the financiers invent to escape the regulators. Next time, those hedge funds and unregulated financiers, by attracting more American capital and lending activity, will have made themselves too big to fail—and the taxpayers will shoulder a bigger burden.

At this point, reaching that scenario would mean breathing a sigh of relief long before it materializes. The government has painted itself into such a tight corner with its socialization of market risk via Fannie and Freddie, we'll need luck to escape this crisis without damage to our economy and finances.

For the government can't destroy the risk that Fannie Mae, Bear Stearns and the rest pose. It can only transfer that risk to taxpayers. Once all of that concentrated risk goes sour and starts to fray America's finances in earnest, the feds' plan is to hope the taxpayers' creditors—including the Chinese government—continue to consider America itself to be too big to fail.

This piece originally appeared in Investor's Business Daily

This piece originally appeared in Investor's Business Daily