"TOO BIG TO FAIL" & BAILOUTS

Here we go again …

According to an April 14th Standard & Poor’s Report, two enterprises with nominally public missions, Freddie Mac (the Federal Home Loan and Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association) may have to be bailed out to the tune of roughly $5 trillion if the economy slides into a deep recession. The rationale is that these for-profit enterprises are seen as too big to fail because of their potential impact on the national economy.

Let’s make this real simple. “Too Big to Fail” is slowly becoming a nice prelude, and euphemism, for industry bailouts. In a darker corner some might call it what it looks like – another form of corporate welfare.

So, the question remains, How did two for-profit enterprises like Freddie Mac and Fannie Mae get into the position where the feds (i.e. you and me) may have to bail them out in the future?

Real simple (actually, I'm oversimplifying here). Both enterprises purchase a bundle of home loans and use the proceeds, plus fees, to guarantee that home loans will be processed and made in a timely manner. They then sell these products to others, who like to be called "investors" (I say this because the "investors" will be at the forefront demanding a bailout should everything fall apart). Freddie Mac and Fannie Mae then use the proceeds to buy more mortgages from the mortgage industry. In doing so Freddie and Fannie (1) create a new class of “mortgage backed securities” that (2) returns money to mortgage lenders, who then (3) make more loans to consumers.

This arrangement facilitates a transfer of funds from Wall Street to Main Street. But it also allows Wall Street and unscrupulous lenders to get off the hook when they push products they know are shady. You know, the "no doc" loans, the Ninja (no income, no job, no assets) loans, and the "liar" loans we saw over the past 5 years. Why worry about them when everyone's bought into the cycle of deception?

Problems also arise when you have companies like Countrywide Financial who go to Freddie Mac for more than $50 billion in loans, and then put up virtually worthless (or soon to be worthless) subprime loan contracts as collateral. This helps to explain why Freddie Mac and Fannie find themselves in trouble today. They’ve gotten wrapped up in a lot of “toxic” loan contracts.

There’s more to this story, but I’ll make this simple: This is what happens when government enterprises, with legitimate public missions (homeownership), underwrite an industry that then gets caught up in a euphoric web of deregulation, easy money, and greed. The taxpayer picks up the tab, while the "investors" lose little to nothing.

These dynamics not only gives legitimate government activities a bad name, but undermines the integrity of the market.

- Mark