The wages of socializing, revisited

The biggest news of the day, and probably the week, is the historic seizure by the government of the two entities it originally created, Fannie Mae and Freddie Mac.

This sorry episode should be a clear warning to all observers of the wages of socializing.

The concern is that many commentators and members of the media will portray it as a failure of free markets and a need for greater government control of various industries. For example, an article on page A15 of today's Wall Street Journal entitled "U.S. Poised for Bigger Role: Mortgage Bailout Marks the Return of Federal Activism" states, "The struggle between market forces and government control is as old as the country," as if Fannie and Freddie represent market forces.

This is completely false.

As we wrote in July in "The wages of socializing" (part one), the dangerous excesses of Fannie and Freddie were a direct result of their status as a government creation: because of the perception that the government implicitly stood behind them, they could borrow more money more cheaply and leverage their bets more aggressively than a regular private corporation would ever have been able to do.

They also lobbied vigorously through the years to prevent any limits to the size of the bets they were making. The supposed justification for these so-called "government-sponsored enterprises" was that they served "a public purpose" (see the Fannie Mae logo above, which describes the entity as "a Shareholder-Owned Company with a Public Purpose"): helping more Americans own homes. As studies linked in our earlier blog post reveal, the percentage of Americans owning their own homes barely changed in the decades since Lyndon Johnson moved Fannie Mae out of the federal government in 1968, increasing by only two percent over the next thirty years.

Because they were seen as just as safe as U.S. Treasury debt (because of their implicit backing from the same source) but paid a slightly higher rate, agency bonds issued by Fannie and Freddie are favored by many conservative investors, from retirees to foreign governments*. Treasury's seizure of Fannie and Freddie and placing them in conservatorship should ensure that those lenders will be protected, and our view is that this outcome is correct: Congress has basically been allowing this "government-sponsored" relationship for forty years (thirty-eight in the case of Freddie Mac, which Congress created in 1970).

On the other hand, shareholders of Fannie and Freddie will probably be wiped out, and this outcome is also as it should be. They were the ones who benefited from the upside when these entities made their aggressively-leveraged bets using borrowed money, and they should be the ones who pay when the bets go the other way.

However, because of the fact that these were government-sponsored entities and not private entities, there is a real possibility that every American taxpayer will also pay -- an outcome that is called "socializing the losses."

According to Treasury Secretary Hank Paulson's plan, as described in his press release yesterday, Treasury has received senior preferred equity and warrants in the conserved entities, and will be paid before the common stockholders if they are able to privatize later at higher valuations, which is certainly possible, thereby saving taxpayers from having to pay for the mess.

Ultimately, the entire "housing crisis" is an indictment of government's attempts to steer the economy (including through the actions of the central bank, and by high-handed Congressional legislation such as the Community Reinvestment Act) rather than an indictment of free markets and private business, as many commentators want to portray it.

Those who are critical of the current situation should realize that it is part of the wages of socializing.

* The principals of Taylor Frigon Capital Management do not own securities issued by Fannie Mae or Freddie Mac, either stocks or bonds.

For later posts dealing with the same subject, see also:

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