Why are we doing this bailout again?

  • Share
  • Read Later

Several commenters to my last post wondered why the heck Hank Paulson & Co. think they need to bail out Fannie and Freddie. I’ll give Paulson’s answer, then translate:

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

GSE=government-sponsored enterprise=Fannie and Freddie; MBS=mortgage-backed securities. And the Preferred Stock Purchase Agreements are the deals Treasury got in return for committing up to $200 billion to keep the two companies solvent.

The issue is that, even though every debt security issued by Fannie and Freddie included the disclaimer that it wasn’t guaranteed by the U.S. government, investors around the world assumed they were guaranteed. And neither Congress nor the Treasury nor the Federal Reserve did anything to disabuse them of that notion. Just the opposite, in fact–the Fed seems to have actively steered foreign central banks into GSE securities.

So the fear is that if Fannie and Freddie were allowed to default on any of their commitments

a) financing for mortgages in the U.S. would almost entirely dry up, for a little while at least

and, even worse,

b) the U.S. government would be seen as welshing on its commitments–meaning that investors would start demanding much higher interest rates on Treasury securities.