Treasury is now intervening in Fannie Mae and Freddie Mac. The stock markets welcomed the move at least for a day, but so far the intervention has not done much more than just making the implicit government guarantee on the government sponsored enterprises (GSEs) explicit. It is important for the U.S. government to formulate a clear plan on how to restructure these GSEs very soon. Otherwise the U.S. would make the same mistake that Japan made in dealing with the financial crisis: protection of insolvent financial institutions in the name of financial stability without seriously restructuring them.
One mistake that the Treasury has already made is its decision to inject public funds before the current shares are wiped out. This is problematic because many expect the Fannie and Freddie to turn out to be insolvent. Maybe even worse, subordinated debt holders seem to escape from sharing the loss. This would blunt the incentive of the class of creditors who could potentially play a central role in monitoring health of financial institutions. This is exactly the same as the mistake the Japanese government made in the 1990s when they explicitly protected all the liabilities of failing banks, not only their deposits but also subordinated debts. Toward the end of the 1990s, even the Japanese government stopped protecting shareholders. When the government nationalized two long-term banks (Long-Term Credit Bank and Nippon Credit Bank) in late 1998, shareholders were compensated for exactly what their shares were worth, which is zero.
In planning the future restructuring of the Fannie Mae and Freddie Mac, it is important to note that subsidization through the GSEs is not the most efficient way to promote housing ownership. For example, Charlie Calomiris convincingly argues that the government could promote housing ownership by directly subsidizing homeowners for their down payment more efficiently than distorting the mortgage market through the GSEs (“An Economist’s Case for GSE Reform” in Peter J. Wallison (ed) Serving Two Masters Yet Out of Control: Fannie Mae and Freddie Mac, AEI Press, 2001, pp.85-106). The intervention for Fannie Mae and Freddie Mac should be considered as a nice opportunity to reformulate the housing policy to make it more efficient.
Another important consideration in restructuring the GSEs and any financial institutions is how to assess the true value of the assets. One should avoid underestimating the extent of losses, which leads to incomplete restructuring and larger losses in the future, as many Japanese banks experienced in the late 1990s and the early 2000s. The key here is conservative estimation of asset values. If the eventual loss turns out to be smaller than estimated, banks can bring those back as profits later. This is exactly what the Japanese banks were forced to do 60 years ago during the successful restructuring of the system wide insolvency (which I visited in my blog in June). After giving zero assessment on many problem assets, the banks created “reconciliation accounts” where they accumulated any surprise profits recovered from those assets. Similar conservatism will be desirable in restructuring the perhaps insolvent GSEs.