What a mess of a week. First Fannie Mae and Freddie Mac become technically insolvent, and the financial institution IndyMac fails and is taken over by the Fed. The problem with the GSMs is that they have over $5.1 trillion of guarantees on mortgages and under $50 billion in equity on a market cap basis. That is a leverage factor of over 100-1, greater than most hedge funds, and much greater than Bear Stearns, Lehman brothers at the beginning of their respective troubles. Add to this equation, fraudulent accounting, political cronyism, and a congress that has ordered it to start guaranteeing loans up to $700,000 (from $400,000) and passed lesiglation having it guarantee another $300 billion of the banks most toxic debt.
This is not good, and fixing it will not be cheap. If congress decides to explicitly guarantee their debts, we are looking at another $5.1 trillion of government debt. This will severely hamper the ability of the government to borrow (not necessarily a bad thing), probably result in higher taxes to service this debt (very bad), drastic reductions in government spending (good) and entitlement reform (good), but also in a real decline in American's standard of living as the dollar would tank (very bad).
The less expensive option would be for congress to shore up the GSMs balance sheet with about $100 billion of preferred equity, and slowly start winding up the two companies over time. This would take several years, but would keep all the guarantees off of the federal government's balance sheet. After the windup, the companies would be dissolved and this monstrosity of a program could be abolished.
These programs show what happens when the government creates moral hazard by distorting the credit markets with guarantees. The reality is that a lot of people who own houses should not be owning houses, and government policies (Freddie, Fannie, the mortgage interest deduction, and deductions for property taxes) distort the true cost of housing.
