You know, when I think about the fate of Fannie and Freddie, I am reminded of the fate of Schrodinger’s cat. Erwin Schrodinger was an Austrian physicist in the 1930s who proposed a thought experiment to illustrate the pecularities of quantum mechanics. Imagine a cat in a sealed box with a flask of poison. You cannot observe whether the cat has drunk the poison. Is the cat alive or dead? (Don’t worry, no cats were harmed—a ‘thought experiment’ means that it was never actually done)
According to most interpretations of quantum mechanics, as long as the box is sealed, that’s not the right question. Until we open the box, the best we can say is that there’s a certain probability that the cat is dead and a certain probability that it’s alive. In some sense, the states of “cat alive” and “cat dead” exist at the same time.
But once the box is unsealed and we observe the cat, the two states collapse down to one. The cat is either alive and bouncing, or unfortunately passed on. And the process is not reversible. If you put the dead cat back into the box again, it will still be dead, no matter how many times you close and open the lid.
What does this have to do with Fannie and Freddie? For many years, Fannie and Freddie have occupied two states simultaneously. On the one hand, they have been operating as private profit-making enterprises, just like any other company. On the other hand, they have been operating with the implicit full faith and backing of the federal government, allowing them to raise money at a lower price than anyone else.
This superimposition of states worked, as long as no one looked in the box. Fannie and Freddie could make lots of money, investors could feel safe, and the government didn’t have to decide whether Fannie and Freddie were really protected or not.
But guess what? The box has been opened, and it turns out that Fannie and Freddie really have been government agencies all the time (you can decide for yourself whether this means the cat is alive or dead). What’s more, once we know they are government agencies, there is no putting them back into the box and pretending that we don’t know. In fact, no matter what Paulson and his friends do, Fannie and Freddie are now permanently wards of the state.
So where do we go from here? First, Fannie and Freddie are not profit-making entities. Their only reason for existence is to protect the housing market against crashes, not to take more risks and make them worse.
The right structure is probably something like the FDIC, which protects bank accounts up to a certain limited amount. The FDIC is funded by an insurance premium paid by banks, with the federal government as the ultimate backstop. In other words, deposit insurance is both limited and costs something.
In the case of mortgages, Fannie and Freddie should be merged into one government agency (Frannie?), which packages and sells mortgage-backed securities. The mortgages would be prime mortgages, up to a certain amount, just like now. The difference is that Fannie and Freddie would charge a fee for the service, which would be required to go into a reserve fund, to be held in case of future problems.
Over time, the reserve fund would grow. By law it would be invested only in low-risk treasury securities. Frannie would not make any profits, would not pay out any dividends, and would not make any other investments. It would just serve as a passive insurance fund. In theory, subprime and altA mortgages could be handled as well, with a higher insurance premium.
It’s going to take a lot of fussing and feuding to get to that common sense outcome. But Paulson is about to find out what physicists learned long ago: You can’t put Schrodinger’s cat back into the box again.