Why We Can’t End Fannie and Freddie Today, Though I Wish I could

A reader wrote me this morning to ask why we can’t just shut down Fannie Mae and Freddie Mac today. I share this frustration, but believe it would not be the best policy choice, as much as it would seem to be the more libertarian response.

As I wrote in my Washington Times piece last week, “The process of eliminating Fannie and Freddie is going to be complicated and hotly debated. They cannot be shut down right now because virtually the entire mortgage market is dependent on them as a wastebasket for toxic mortgage debt. But a long-term strategy for dissolving Fannie Mae and Freddie Mac can and should be created now.”

The reason why is based in the fact that ending the GSEs tomorrow would put the market into quantifiable disarray. I do not think this is prudent. The government has promised to back Fannie and Freddie and responsible individuals, investors, and firms (as well as irresponsible ones) have made bets in the market based on that information—even though it is a bad policy response from the government. We would be doing these people and firms a disservice by unfairly reversing course on them instantly.

I should note, that this reasoning does not support bailing out firms. Prior to the Bear Stearns bailout there was no explicit guarantee from the government, rather investors bet on both a belief in market resilience and an implicit promise from the government to prop up market failure. Those investors were taking their risks with non-explicit information. This is a different scenario. Imagine if you had invested in a firm based on the fact that the government guarantee was allow them to become profitable. You would want fair warning that the guarantee was coming to an end.

This is why I suggest in my artlce and previously on this blog, that they be wound down in an organized way over the next several years. I will be recommending in a forth coming policy paper, to be published by Reason Foundation, that the GSEs be banned from buying or guaranteeing any new mortgages by the end of 2010 (or 2011 if its more politically palatable). This would force the market to adjust its activities based on the change in government assistance. It would also allow for investors to alter their bets. Since the GSEs are already worth virtually nothing, there would be little to no shareholder loss.

Then, at the same time as the GSEs are ending their market operations, they will be put on track to have all assets and parts of their portfolio sold off over the next five years or so. The proceeds would go to pay Fannie and Freddie debt holders—aka the U.S. government. At the same time, the GSEs should be put on the U.S. budget since they are, for all practical purposes, nationalized. Designing such a plan would take a lot of time, and will require numerous, dragged out deal sessions as potential buyers do their proper due diligence and ensure they are not taking on debt that will drag them down.

Obviously, this is not the most ideal for those who see the GSEs as failures of a market intervening government. They are the compromises of political realities and the reality of the market as it exists today.