"No Bailouts," So You Say Mr. Paulson?

While Paulson has hinted that there will be no government bailout for Freddie (NYSE: FRE) and Fannie (NYSE: FNM), he clearly left the door open to intervention.

"It is clear that some institutions, if they fail, can have a systemic impact." However, financial players need to be disciplined in managing risk and not expect the government to fly to their rescue, he added. "For market discipline to effectively constrain risk, financial institutions must be allowed to fail," he said. 

Let’s take a look at the implications of what he has said. First you need to understand that a “bailout” can be interpreted in many different ways. Formally speaking, a bailout of Freddie and Fannie would entail the government going in and capitalizing these firms by however much was needed to remain solvent. This could be done by one of two ways. Either a carte blanche of funds supplied by the Fed, or by creating a conservatorship. Under the latter scenario, shareholders would most likely lose everything because the companies would be removed from the public exchanges and run in a manner similar to bankruptcy.

Either way, taxpayers will be fitting the bill. The Fed is going to end up printing a lot more money to try and get out of this mess and that is going to worsen inflation, sink the dollar and cause oil prices to soar to new highs. Yet, everywhere you look the headlines read “Paulson: No Bailout for Fannie Mae, Freddie Mac.” In my book, “no bailout” means no bailout; not by the U.S. Treasury, not by the Federal Reserves and certainly not by the taxpayers. In my opinion, Paulson is basically trying to tell the small and mid-sized banks that you won’t get any help while the big players such as Fannie and Freddie will since “if they fail, (it) can have a systemic impact."  

I say let all of the banks, mortgage companies, bond insurers, and Wall Street come together and figure out how they will handle it. These guys need to be put on notice that government bailouts of any kind are not in the cards. Bailouts cannot be intermittent in a free market economy. All they represent is socialism for corporations. If these guys aren’t forced to find their own way out of this mess, it will create a moral hazard, which will allow the same mess to happen again in the future. In fact, according to the dictionary, one of the definitions of moral hazard states:

“The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.”

Well isn’t that exactly why we have the current mess?  All of the players in the mortgage loop misled and in many cases lied about assets, liabilities, and credit capacity. And the lack of any punishment or real regulation, combined with the lure of money created an incentive to take unusual risks. No new regulations or laws are going to prevent moral hazards in the future. They have tried that over and over. The only way to minimize moral hazard is to not only let the banks fail, but punish those who acted dishonestly, especially the guys at the top.

As we know, that won’t happen because this is America, land where big money sets you free. It’s funny how so many Republicans (and I’m a Republican who won’t be voting for McCain) preach how America’s free market system is so great while denouncing government involvement at every opportunity. They label any type of government intervention as a socialist policy, so as to give it a bad name. Yet, most of them do not realize how badly the free market system is in need of repair.

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