On Sunday evening, Paulson announced a proposal by Treasury to have Congress raise the $2.25 billion it is allowed to loan the two firms, and even open the door for the federal government to buy shares in the two companies if needed. The Fed announced it stood ready to loan money to the firms if they needed access to funds ahead of congressional actions.
Today in congress, Bunning, a longtime critic of Fannie and Freddie, said ``The taxpayers have reacted and the market has reacted to your plan by driving down Fannie Mae shares 26 percent today, right now,Freddie Mac's are down 29 percent at this moment, just in case you are interested in how the markets are reacting to your wonderful plan.''
Then Paulson said, though he wanted the guarantees, but he did not expect to use them. Bunning then said "There's a lot of us who would like to believe what you're saying, But we're skeptical. Anytime we approve something, it gets used."
Now this is very interesting, because I can sympathize with both positions. If the government gives authority, is it money potentially it will never see again. But, this is a truly exceptional case. The essence of managing a Treasury or central bank, is to follow two rules: don't inflate the currency and provide conspicuous liquidity in panics. Pulling money out of the system during panics is counterproductcive, as Friedman and Schwartz documented in their seminal Monetary History of the United States. This panic is highlighting why Hoover and the Federal Reserve chiefs at that time thought it was prudent to take money away from banks during the depression: don't throw good money after bad. But the issue is, people do occasionally panic en masse, as exampled by the lines outside of IndyMac, even though their deposits are guaranteed and the government has never Welshed on this guarantee.
But the question was put well by Bunning: Why should I believe you? This was in reference to Paulson's opinion they would not actually use the guarantee. Paulson's answer was, he believes it himself, and has worked in finance for a long time. I think instead he should have outline why he things Freddie and Fannie are viable long run. One thing he could have pointed to, was that delinquency rates for new pools are declining, so we have turned the corner. A second reason is that a big part of that reason is that they get cheaper funding than all their competitors via the government backing, which is a huge advantage in a scale game. Of course, this is kind of embarrassing, because Fannie and Freddie have traditionally been the primo patronage jobs in DC, and and so it's pretty sordid thing we are saving. But now is not the time to kill them. I would rather provide them with liquidity, then slowly constrain the relevant mortgage sizes for which they get Federal backup.