Image

Recently, as mortgage companies began to fail, the U.S. encouraged Fannie and Freddie (which already owned or guaranteed $5 trillion in mortgages) to buy still more mortgages. This aggravated the problem. Since the agencies’ capital was inadequate, they should have been reducing risk.

In a similar vein, federal regulators seized IndyMac, a Pasadena bank whose depositors had crowded the door demanding their money and which became the second-biggest bank failure ever. The head of the Federal Deposit Insurance Corporation immediately announced that IndyMac would stop foreclosing on mortgages. No doubt this was pleasing to California homeowners, as well as to the 55 congressmen and senators who represent them (and who help to oversee the F.D.I.C.). But it amounted to yet another giant socialization of risk and to a dubious precedent.

What if politically mindful regulators now lean on Freddie and Fannie to halt foreclosures? Exactly which losses are immunized and, just as important, who gets to decide? Similar questions have been raised by the Fed’s various actions to protect Bear Stearns and other investment banks and their collective creditors. In the space of several months, a wide swath of American finance has ceased to operate under normal rules.

Fixes are being introduced, and the next administration will very likely initiate its own reforms. The Fed has tightened mortgage rules; higher capital requirements are coming. Also, better accounting and disclosure rules would help investors to understand the often-complex assets that banks own.

But there is a difference between increasing transparency, with regard to risk-taking, and underwriting losses. The government should get out of the business of assuming risk  which hinders markets in a function they can handle better. With investors conditioned to look for rescues, it will not be easy to get the genie back in the bottle. A good first step would be to draw a bright line between Fannie and Freddie’s outstanding obligations, which total $1.5 trillion, and the borrowings they undertake in the future as their current paper matures. Their current debt is presumably socialized. But if the Treasury were to announce that new obligations were not protected, markets would gradually force the beleaguered twins to both raise more capital and shrink their asset bases. The U.S. might even consider splintering the companies, AT&T style, into pieces. The goal should be to ensure not that they never fail, but that for Fannie and Freddie and for other institutions, failure reacquires its proper status in a capitalist society: that of a tolerable event.