Vote of No Confidence

Well, I’m glad to see the market is finally responding intelligently to the truly horrible news that the government is proposing to prop up Fannie Mae and Freddie Mac by (potentially) buying their equity. Fannie opened up sharply today, but is now off; Freddie is similar.

The proposal is awful, awful, awful. The whole point of calling something “too big to fail” is that it creates confidence out of thin air. Because you believe nobody would allow the GSEs to fail, you agree to lend to them without concern about their financial health. Nine times out of ten, that’s enough to actually get past real problems; a great deal of finance, particularly in this era of fiat currencies, amounts to a sophisticated confidence game.

But the tenth time, when the fundamentals really matter, and confidence isn’t enough to get you through, you have a real problem. Because at the point where the government actually ponies up the money, the game ends. Lack of confidence has been irreversably revealed to the entire market. Once the government even suggests that it would be willing to do what it had never explicitly promised in the past, the market will demand that promise be made good – or else refuse to lend to the GSEs. So the attempt to prevent a panic guarantees the panic – and the bailout. Game over.

There is lots of blame to go around for the situation at Fannie and Freddie. Like the ratings agencies whose failures are so close to the center of the housing mess, Fannie and Freddie are peculiar hybrids between public utility and private for-profit company, and so can be – and are, legitimately – criticized from both the right and the left. But since a hybrid system is what we have – and will have, for about as far out as I’d care to project – these are properly only the starting points for criticism, not the end points.

But whatever answers we come up with either for how we got here or what the long-term solution is, as a short-term matter the actions our government is taking now are very dangerous. There are precious few bullets left in the rifle, and the bear is still coming at us.