The bailout of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) means two out of three of the nation’s GSEs are backed by the taxpayer. However, they remain publicly traded outfits beholden to their shareholders.

The question, then, is: What happens if Fannie and Freddie, enjoying the backing of the government, venture into riskier areas of consumer finance to boost earnings. Are we looking at the spread of nationalization beyond the mortgage market?

This from Chris:

It is interesting to note that the GSEs are among the most leveraged of all US industries. Only federally insured commercial banks and savings institutions exceed their debt ratios. Moreover, as Cochran and England point out, if you add back certain off-balance-sheet liabilities (like mortgage-backed securities which the GSEs guarantee) there is approximately $80.55 of debt for every one dollar of equity in Fannie Mae and $64.70 in debt for every one dollar of equity in Freddie Mac.

The fact that the market implies that GSE obligations are backed by the US government only adds to their ability to further leverage their assets. Perversely, as Cochran and England note, “the ambiguous nature of the GSEs’ relationship to the government may reverse customary market incentives. In sharp contrast to the concerns that arise when a private corporation increases its outstanding debt, investors in GSE debt could expect that the more debt Fannie Mae has outstanding, the less likely the government will be to allow it to default. Some investors may thus interpret increased GSE debt as embodying less risk rather than more.”

The risk to the GSEs is that an economic downturn results in falling home prices, increasing delinquency rates and thus leading to loan losses. With the GSEs’ high leverage, it won’t take much in the way of losses to cause some significant damage to their financial health. As James Grant recently observed, “Ignorance about tomorrow is a constant of human affairs. Submission to this truth is what’s variable. In finance, submission entails a healthy fear of leverage.” The GSEs are operating as if the future is certain and prosperous.

An explosive concoction has been created with the GSEs. The GSEs have increasingly dangerous levels of debt, coupled with an implicit government guarantee that seems to encourage even more debt. In the case of Fannie and Freddie, they are publicly traded companies accountable to shareholders for delivering earnings growth that is going to be increasingly difficult to deliver as they grow to the limits of their market. Thus, they are faced with the prospect of lower earnings growth or of finding a way to expand into other (riskier) areas of consumer finance – and further spreading the threat of nationalization beyond just the mortgage market.

The only way to correct this problem is the same way all socialistic practices are corrected – the government’s involvement must be severed completely. Just because the GSEs have led a charmed life so far is no reason to infer that their future will always be so bright. Socialism is not dead; it is alive in institutions like the GSEs, which are for all practical purposes government agencies.

It has often been said that there are no free lunches. Surely, Americans cannot continue to subsidize (indirectly) mortgage finance without cost. What most Americans cannot see is that such subsidization of the mortgage industry has led to the assumption of a great deal of risk on the part of the taxpayer. The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess. Like Russian roulette, the longer you play, the more certain it becomes that you will bear the risk for playing.

Source: Mortgage Market Socialism