The muddle-through approach

tauringhuang.

America’s government tries a quick fix for the intractable problems of Fannie Mae and Freddie Mac
FANNIE MAE and Freddie Mac, the two government-supported mortgage giants at the centre of America’s housing market, pose a particularly acute problem for the Bush administration. Not only are they too big to fail. They are almost too big to rescue.

They hold or guarantee some $5.2 trillion of the nation’s $12 trillion of mortgages, backed by the thinnest wafer of capital, meaning their collapse would imperil the already paralysed American housing market. Yet as Joshua Rosner, an analyst at Graham Fisher, a research firm, points out, nationalising them, a stark choice for the government since their shares tumbled last week, would “result in a doubling of the federal deficit, a further collapse of the dollar and unthinkable implications for the Treasury’s cost of funding in the debt markets.”

Those two unpalatable options—failure or rescue—led the Treasury on Sunday July 13th to announce several stopgap measures aimed at restoring confidence in the two institutions, although it fell short of fundamentally reshaping them. The measures may buy a bit of time, but they are unlikely to put to rest highly sensitive questions about the future of Fannie and Freddie, leaving a large cloud looming over global financial markets.

The Treasury’s three-part plan, announced by Hank Paulson, the Treasury secretary, is to increase its line of credit to the government-sponsored entities (GSEs), which currently stands at a paltry $2.25 billion each. The Treasury also seeks authority to buy stakes in each company if necessary, and wants to give the Federal Reserve a greater role in oversight of the GSEs. Separately, the Fed's governors said that they had granted the New York Fed licence to lend to Fannie and Freddie if necessary, against suitable collateral.

Mr Paulson’s announcement, made overnight on the steps of the Treasury just before Asian financial markets opened, gave some support to the dollar, which had wobbled last week as the share prices of Fannie and Freddie halved. As Mr Paulson made clear, part of the problem with the two institutions is that their debt is held by investors around the world. That includes many central banks. The fear is that a sudden collapse of either institution might pose a threat to the dollar and the global economy.

The Paulson plan is aimed at ensuring that both institutions have enough liquidity to conduct their day-to-day businesses of buying mortgages. It came on the eve of a $3 billion debt-auction by Freddie Mac on Monday, which the government will be eager to succeed, to show that the GSEs are still able to raise money in the capital markets. The drying up of liquidity has bought down firms such as Bear Stearns, an American investment bank, and Northern Rock, a British mortgage lender, with devastating speed in the past year. Last week regulators took over IndyMac Bancorp, a mortgage lender, in one of the biggest bank failures in American history. Even though Fannie and Freddie have always been considered, because of their size, to have implicit government support, the Treasury will not have wished to put confidence in that to the test at an auction.

Less clear is the status of shareholders in Fannie and Freddie. The two firms are considered “the odd couple” in American finance because they are owned by shareholders, yet investors have always believed in that implicit government backing. Now that support has become explicit, shareholders must be worried about the price they will have to pay. They may have to provide more capital to Fannie or Freddie, or risk losing their stakes to the government. As double-or-quits bets go, there cannot be many worse than that—not least because a system that provides privatised profits with socialised losses cannot be allowed to persist.