Big bailout magnifies risks

The immediate reaction to last week’s federal takeover of Fannie Mae and Freddie Mac was overwhelmingly positive. Equity markets rebounded, mortgage rates dipped, and interest rate spreads between

Treasury bonds and other debt narrowed. The financial community and investors seemed to breathe a collective sigh of relief at the placing of the two government-sponsored entities under federal conservatorship.

The takeover appears to have averted a looming crisis in the mortgage and credit markets, and brought hope to the troubled housing market. Ironically, however, the government rescue, which increased the politicization of the U.S. economic landscape, may lead to bigger problems.

The two recent federal interventions in the financial markets — the outright takeovers of mortgage giants Fannie and Freddie, and the assisted takeover of The Bear Stearns Cos. Inc. of New York — send several ominous signals.

First, of course, is the message that the federal government stands ready to bail out big, troubled financial institutions. Should any other American financial giant face a crisis of market confidence, the government is more likely than ever to step in.

While the greater possibility of rescue may calm lenders, depositors and other customers of these institutions, it also perversely increases systemic risk. Through its willingness to intervene, the government implicitly provides a safety net for financial players who otherwise would be compelled to be more cautious.

When profits are privatized and loss is socialized, the inoculative protection provided by risk becomes ineffective.

Then, of course, there is the cost.

In the case of Fannie’s and Freddie’s bailouts, some worst-case scenarios estimate that taxpayers face a bill of $250 billion or more. Our debt-laden public and private sectors can ill afford additional obligations.

Perhaps most disturbing is that the bailout generated so little concern about the expansion of the public sphere. Given that most mortgages are securitized, the government and politicians now will have a greater role in deciding who has access to mortgages, and at what price.

Fannie of Washington and Freddie of McLean, Va., aren’t strangers to politics.

Created in 1938 as part of the New Deal, the Federal National Mortgage Association guaranteed government-issued mortgages until 1968, when it was privatized. The Federal Home Loan Mortgage Corp. was a creation of the Emergency Home Finance Act of 1970.

But even as private-sector companies, Fannie and Freddie were never typical. They were committed to serving shareholders, but they were also supposed to encourage homeownership, often by committing capital to mortgages whose holders were less than stellar credit risks.

The public/private compromise ultimately proved untenable.

The public sector is now in charge of the nation’s mortgage market. Rather than reducing risk, we likely have exchanged one set of risks for another.