It's Time to Unload Freddie and Fannie

But higher interest rates are just the tip of the iceberg. What will make this failure such a big deal is that this current fiasco is a carry-over from the old savings and loan mess from the 1980s. While the government did a lot to get that behind us, it did one thing we still have not paid for. It issued new capital to banks and thrifts via Fannie Mae and Freddie Mac guarantees. With the Fannie Mae guarantees, the banks could then show better capital ratios and also earn fees on the volume of mortgages originated. It created instant solvency for other companies on the basis of perceived credit worthiness from an implied government guarantee.

This problem has the potential to cascade across the financial sector and dwarf the subprime issues. It will definitely affect U.S. financial institutions that will see the market value of these holdings decline from interest rate and credit spread deterioration. These firms will be doubly damaged if they invested their surplus in Fannie Mae or Freddie Mac securities that once were considered safe.

As this crisis unfolds, it will be very clear to all that it was a huge mistake to assume that the government would step in and protect investors. That's not their mandate.

So whose job is it to tell the world that this GSEs' support system is broken? Theoretically, the rating agencies should have pulled the power on the runaway mortgage train. Just imagine what would happen if overnight one of the rating agencies really decided to downgrade Fannie Mae or Freddie Mac debt in response to credit deterioration.

Unfortunately, Bernanke was right. The Fannie and Freddie failures will be remembered for all time as the ones that started the U.S. market downturn. Too bad the rating agencies appear to have missed this one.

>To order reprints of this article, click here: Reprints