Bailout Necessary, but Dangerous
The two financial giants either own or guarantee about one half of the outstanding home mortgages. It has become clear in recent weeks that the problems plaguing the two quasi-public companies were much worse than originally thought.
If either of these mortgage giants had failed, the resulting domino effect could has crippled the U.S. economy and undoubtedly spilled over into the world economy.
The rescue plan may cost U.S. Taxpayers $40 billion, according to some estimates. However, almost every estimate of how bad the credit crisis is has been too low by a lot.
The rescue was necessary, but it raises the dangerous precedent of taxpayers bailing out reckless behavior in the financial markets. This isn’t the first time taxpayers have been on the hook to save a company deemed to big or important to fail.
Freddie and Fannie have been playing fast and loose with financial markets for years. Many suspect that the managements assumed the government would step in if they got in trouble.
Events are unfolding that prove the implied safety net was in-place.
The danger is now and has always been that the management of large and important financial companies will take more risks because of the implied safety net.
The Treasury’s bailing out of Freddie and Fannie may re-enforce this dangerous mindset.
This distorts the risk-reward equation that should drive every investment decision. If companies believe they can make risky deals, which is at the center of the credit crisis, with little ultimate risk, what’s to prevent them from seeking even higher returns by taking more risk?
Is the answer more regulation? Certainly some new regulation or oversight is called for to prevent a repeat.
The other part of the equation is an investment community that was too eager for hot deals to ask many questions. Investors should expect risk and potential reward to be determined by the market. When there is an implied bail out, it changes the risk-reward relationship.
Comments
What about Bank of America’s role in this? Freddie and Fannie may WERE warned by the government during the Clinton years to stop granting mortgages to people who couldn’t afford them and ignored the warnings but just as culpable is Bank of America. It really looks like they picked up Countrywide with the intent of using their connection to Senator Dodd to stick the taxpayers with the coincidental $700 billion in bad mortgage losses it had.The worst thing we EVER did was create the federal reserve bank. Had this monstrous waste of an entity never been created we wouldn’t be in the financial hole were in now. Iinsitutitons would HAVE to be cautious and show profits because they’ed know there was no safety net for them! They’ed be at the mercy of the tax payers and investors! Peace.