Fat Fannie and Freddie

The rapid deterioration of Fannie Mae’s and Freddie Mac’s financial health made a federal takeover of the mortgage giants inevitable. Yet it still seemed sudden when the government swooped in over the weekend, putting the companies under the strict control of its federal regulator to avert an even larger taxpayer-funded bailout. Just two months ago, officials at the Treasury Department and the Federal Reserve tried to reassure Fannie and Freddie shareholders by offering to shore up the companies with low-interest government loans and, potentially, an investment in their stock. They said the companies held enough money in reserve and that no further action was likely to be needed -- an argument backed by the companies’ regulator but hotly disputed by Wall Street analysts and other experts.

As it turns out, the skeptics were right. The two companies, which guarantee or own about half of the mortgage debt in the U.S., were tens of billions of dollars short of the capital needed to protect against mortgage defaults, which have spread from subprime to prime and other loans the companies back. And instead of giving lenders and investors more confidence in Fannie and Freddie, the government’s previous steps actually spooked them, preventing the companies from building up reserves. That’s why Treasury Secretary Henry M. Paulson announced Sunday that the two companies were being placed into a conservatorship, with the government committed to investing up to $200 billion in them.

The move raises immediate questions about the fate of those who own shares or bonds issued by Fannie and Freddie. Defaulting on the bonds, which were bought by governments, pension funds and other institutions around the globe, should be off the table because of the long-standing (albeit only implicit) federal guarantee. It would undermine the U.S. government’s financial credibility and raise the cost of borrowing, which this heavily indebted nation can ill-afford to do. The companies’ shareholders had no such implicit protection against risk, and wiping them out would eliminate any chance of their profiting from the government bailout. But if the ultimate goal is to get the government out of Fannie and Freddie, it makes sense to let the shareholders keep their holdings without dividends or interest during the conservatorship, in keeping with Paulson’s plan.

Defenders of the two companies argue that the government should be in the mortgage market, and that the implicit guarantees for Fannie and Freddie helped them bring the cost of mortgages down when they were healthy. But the fact that Fannie and Freddie are privately owned allowed them to rack up profits for shareholders and executives while dumping the risk on taxpayers. That’s unacceptable.

The companies also grew far too large with too little supervision, and their limited mission kept them from diversifying their holdings to reduce the danger posed by a downturn. That mission -- to make housing more affordable -- is close to apple pie and motherhood in Washington. Yet even if you believe that the government should help working-class Americans afford a home, that’s no justification for these companies dominating the secondary mortgage market. Helping 20% of the borrowers, maybe, but almost half? No way.