23 Aug 2008

The Unintended Consequences of Bailouts

All Posts No Comments

“Despite” the federal government’s recent assurances, Freddie Mac and Fannie Mae continue to struggle. From today’s Washington Post:

A major credit rating agency cut the preferred share rating on Fannie Mae (FNM.N) and Freddie Mac (FRE.N) amid mounting concern about the ability of the two largest U.S. home funding providers to access capital, in the latest blow before a widely expected government bailout.

Gee, why is this happening? Oh, maybe this guy can help us:

Early in the day, influential stock market investor Warren Buffett told CNBC there is a “reasonable chance” that Fannie Mae and Freddie Mac stock will get wiped out in a government rescue, reflecting market sentiment that has slammed the companies’ shares toward 20-year lows this week.

This is why government interventions in the economy never work as they “should.” At first it sounds odd that stock could get wiped out by a “rescue.” What’s happened is that the government was very austere in its handling of the Bear Stearns meltdown, so as not to set up a “moral hazard”–where investors become reckless because they think heads-I-win, tails-the-feds-bail-us-out.

Yet ironically, they now have the opposite problem. Now if there is a financial firm that’s on the ropes, the very presence of the government, waiting in the wings to “help” with a rescue that is very bad for regular shareholders, distorts the situation. People are less likely to pump in new capital, and so the fear of an austere bailout becomes a self-fulfilling prophecy.

Here’s a thought: Instead of trying to micromanage the financial markets, maybe the people in DC should have some humility. They don’t exactly have a good track record when it comes to financial discipline.

If the regulators would just stop interfering in the market, the morons on Wall Street would get weeded out and everybody could get back to work.

(For a related article, here I discuss the absurdity of restrictions on naked short selling.)

Comments are closed.