Steps Should Be Taken To End Culture Of ‘Too Big To Fail’

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This month marks the third anniversary of the federal seizure of Fannie Mae and Freddie Mac, the “too big to fail” government-sponsored enterprises (GSEs) that did so much to cause the 2008 financial crisis.

Fannie and Freddie epitomize the danger of what former American Enterprise Institute president Christopher DeMuth has described as “fusion enterprise,” or “the intermingling of politics and power with finance and commerce.” This perverse business model allows companies to reap enormous private profits while enjoying either implicit or explicit public backing for losses.

Investors knew the GSEs would never be allowed to fail; therefore, Fannie and Freddie grew to dominate the secondary mortgage market. They recklessly took advantage of the government’s implicit financial guarantee to borrow at below-market rates and purchase trillions of dollars of mortgages, including those made to risky, so-called subprime borrowers.

The easy credit they acquired fueled rapidly rising home prices. As prices rose, so too did the demand for even larger mortgages, so Fannie and Freddie looked for ways to make even more mortgage credit available to borrowers with a questionable ability to repay. By 2008, the two GSEs held nearly $5 trillion in mortgages and mortgage-backed securities. They were overleveraged and “too big to fail.” It was a textbook example of moral hazard on a massive scale.

To date, the bailout of Fannie and Freddie has cost taxpayers a net total of $130 billion, according to the Congressional Budget Office. Based on GSE obligations incurred through March 2011, the CBO estimates that the ultimate “fair-value cost” of rescuing Fannie and Freddie will be roughly $317 billion.

Every day Fannie and Freddie maintain their current status is a day taxpayers are subsidizing their activities. These two institutions should have been revamped long ago. Unfortunately, not only did the 2010 Dodd-Frank financial reform legislation fail to address Fannie and Freddie, it enshrined into law the doctrine of “too big to fail.”

The bill identified certain financial firms (with assets of $50 billion or more) as “systemically significant,” and it authorized a panel of Washington regulators to give other companies that same designation. In other words, the bill empowered the government to pick winners and losers by declaring that the failure of some institutions would pose a risk to the entire financial system, and, therefore, are implicitly backed by the federal government.

As American Enterprise Institute scholar Peter Wallison has written in the Wall Street Journal, designating particular companies as systemically important “will signal to the world, removing all doubt, that the government will take steps to prevent the failure of these firms, giving them advantages in the marketplace. If the funding advantages that have already appeared in banking are spread to other industries, large companies will be put in a position to drive smaller rivals out of business.” The overall effect would be to increase financial instability, distort competition, and set the stage for future taxpayer-funded bailouts.

President Obama has said he opposes future bailouts and wants to end the culture of “too big to fail” institutions. If so, he should (1) offer a concrete plan to end Fannie Mae and Freddie Mac and (2) support measures that will truly end both implicit and explicit government bailout guarantees for all financial firms. Until then, “too big to fail” institutions will continue to exist.

Sen. Jon Kyl is the Senate Republican Whip and serves on the Senate Finance and Judiciary committees. Visit his Web site at www.kyl.senate.gov or his YouTube channel at www.youtube.com/senjonkyl.

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