. . . but not the Hippopotamus

Over the weekend it was announced that Uncle Sam – the Treasury Department – was seizing mortgage giants Freddie Mac and Fannie Mae.  This is the latest effort of the government to speed up the recovery of the housing and credit markets, and the decision has been met with mixed reactions.  The move is considered by most a “stop gap” that pushed real decision-making off until after the presidential election (as if there wasn’t enough for the next President of the United States to deal with already).

Aubry & Eustice, LLC strongly believes in the importance of the decision-making of the “free market.”  The free market, as defined by www.dictionary.com, is an economic system in which prices and wages are determined by unrestricted competition between businesses, without government regulation or fear of monopolies.  However, even though it was a direct violation of a true, unrestricted free market, the bailout of Fannie Mae and Freddie Mac is something that likely needed to be done.

Freddie and Fannie do essentially the same thing: they “connect Main Street – the residential mortgage market – to Wall Street – dealers and investors.” (This is a direct quote from Freddie Mac’s website www.freddiemac.com)

When you go to your local bank to secure a mortgage for your home, the chances are very high that your local bank is going to sell your mortgage in the “secondary market.”  Freddie and Fannie are the “middle men” from your local bank to investors, mutual funds, hedge funds, other banks, etc.  By buying mortgages in the “secondary market,” Freddie and Fannie are able “to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates.” (from Fannie Mae’s website www.fanniemae.com)

This sounds like a very good and noble purpose, and originally, it was.  But recently, it seemed as if it became a right – instead of a privilege – for every American to own a home.  On the other side, lenders, mortgage brokers and banks took advantage of the system (or flaunted the laws altogether) and there were too many people owning homes and carrying mortgages they could not pay for.  Borrowers began to default on their obligations and the media began to scream about a “credit crisis.”  This so-called “credit crisis” was only exacerbated as the housing market began to crash, leaving many investors holding loans, as investments, that were not going to be recovered. Fannie and Freddie tried to get rid of as many of these notes as they could, but were left holding mortgages that no one would buy.  This is where we have been for several months now.  Fannie and Freddie are holding notes that are just not being paid.

So what’s the problem?

The cold-hearted capitalist says, “So what.  They made bad business decisions.  Let them fail!”  The free market would support this sentiment.  But there is one major problem: the implied guarantee of the United States government. Fannie and Freddie are not as independent as they may seem to be.  The government created Fannie Mae in the 1930s and reorganized in 1968 to be a “shareholder-owned company, funded solely with private capital raised from investors on Wall Street and around the world.”  Freddie Mac was created in 1970 in much the same way.  However, the guarantee of the United States government was always implied.  This means that with a “wink and a nod” the US government has always said to Fannie, Freddie and its shareholders that it would always be there to take care of them if they ever got into financial trouble.

Why did the government bailout Freddie Mac and Fannie Mae?

There is one main reason and two secondary reasons why the government has decided to take over Freddie and Fannie.

1.   To make the guarantee explicit; to ensure that everyone knew that the US government was going to do what everyone thought they would do.

a.   Fannie and Freddie hold about half of the mortgages in the US.  What would happen if the holder of half of the mortgages went belly up?

b.   The financial markets were screaming for the bail out.  This was seen today.  Just about all of the major markets were up, and up big today.

What about the Hippopotamus?

There is a book that I read with my children from time to time called “But Not the Hippopotamus.”  It is a book with cute little phrases about animals and how sometimes other animals get left out . . .

“A bear and a hare have been to the fair.  But not the hippopotamus.”

There are 5 or 6 examples of how the hippopotamus is “left out.”  Then, at the end, the animals turn around and ask the hippopotamus to join them on a run.  All of the animals begin to run, feeling good about their group; and yet the book ends with “. . . but not the armadillo.”

This is a very fun book to read to young kids that teaches a good lesson about including everyone and making them feel good.  However, the real world is not that way.

I have heard and read several commentators, economists and politicians complaining over the last couple of days about the Fannie/Freddie bailout.  “What about the airlines?” cried one commentator.  “What about the auto industry?  Are they next to be bailed out by the government?  I thought we were a capitalist country that believed in the free markets?” bellowed another.

The problem, though, is this: these other industries are not going to (or at least, they should not) get bailed out.  The reason is very simple.  Without banks and liquidity, capitalism just doesn’t work.

You may remember Jimmy Stewart’s character in It’s a Wonderful Life. “George Bailey” is inside the Building & Loan trying to control a “run on the bank” while everyone was clamoring to withdraw their money.  “Well, your money is not here . . . it’s in everyone else’s home and business.”  Banks have a good amount of money on site; but most of their money is loaned out to other customers.  So, the action taken by the United States government over the last couple of days has, in essence, prevented a “run on the bank.”  At least for now.

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