The perverse (yet persuasive) logic of letting Fannie and Freddie take more risks

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Okay, so we’re in a middle of a big crisis brought on, in part, by the failure of financial institutions to maintain large enough capital bases as insurance against the risks they’re taking. So now, in an effort to make the crisis go away, the Office of Federal Housing Enterprise Oversight announces this morning that it’s going to let mortgage giants Fannie Mae and Freddie Mac reduce their capital bases. (And markets cheer.)

The reasoning, also behind several other moves by OFHEO and Congress lately, is that whatever troubles Fannie and Freddie might have, they’re the least dysfunctional part of the U.S. mortgage market right now, so finding ways to let them buy more mortgages can only help.

This is probably right. Private lenders and investors are doing all they can to reduce their risk exposure right now–and for good reason. But by all doing it at the same time they’re actually increasing the risks to the overall financial system and the economy. So if government, and government-sponsored enterprises like Fannie and Freddie, don’t increase their risk-taking, we might be in for a really horrific financial crash. The key, though, is making this increased risk-taking temporary. That is, rolling it back when credit markets start functioning on their own again. Which, in the case of the lobbying juggernaut that is Fannie in particular, may turn out to be really hard to do.