I won’t discuss the justifications for rescuing Fannie and Freddie. I will, however, argue that, even taking as given the objective to maintain the role of Fannie and Freddie in US residential mortgage financing, the Paulson-Bernanke initiative is a crummy way to go about it.
Fannie and Freddie ought to have been nationalised. They are not viable as private institutions without a government guarantee for their liabilities. They were created to subsidize residential mortgage financing. If they do indeed subsidize mortgage borrowing, then they cannot also raise funds on commercial terms and earn the required risk-adjusted rate of return on their equity.
As I have not been able to access the US Treasury’s website since Sunday evening, I am not sure whether the authorisation to purchase the equity of the two GSE refers only to the existing equity, to new issues or to both. Whichever it is, it is clearly supportive of the share prices of Fannie and Freddie. Supporting existing shareholders of these two GSEs is not a legimate government activity.
Outright nationalisation, with the existing shareholders getting nothing and without any guarantees for the existing creditors would be another fair and efficient option. So would the purchase by the government of all the mortgage and mortgage-related assets of the two GSEs. Existing creditors and shareholders would be paid in order of seniority without any guarantees.
Both the option to acquire equity in the two GSEs and the extension of their credit lines represent contingent liabilities for the US Treasury and thus for the US tax payer. Extending primary discount window access to Fannie and Freddie exposes the Fed to a contingent liability.