Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies, explains that the Paulson plan alleviates concerns about the potential failure of Fannie and Freddie but does not address the underlying problem with the GSEs: that government backing creates moral hazard. He laments that Congress always responds to failed regulation by crafting more of it.

Arthur F. Burns Fellow Peter J. Wallison

Assuming that congress adopts the Paulson plan, the Fannie Mae and Freddie Mac crisis is likely to fade away. The secretary's package assured the markets that the U.S. government stands behind Fannie and Freddie, and hence assures a continuing flow of the funds they need to operate. This will enable them to survive until and unless their regulator declares that they are insolvent, and this is unlikely to happen if housing prices stabilize over the next three or four months. Of course, if housing prices continue to deteriorate, Fannie and Freddie will both be in jeopardy of insolvency, in which case the government will have to step in and take control of them. But this I assess as unlikely.

With Fannie and Freddie successfully, if temporarily, tucked away, the greatest danger we face is failing to learn the lesson they teach--that government backing for a private, shareholder-owned company will inevitably come to a bad end. Government backing creates moral hazard, inducing lenders to shed the wariness they usually display in lending to an ordinary company; the easier money thus obtained, and the lack of market discipline, permits managements to take extraordinary risks in pursuit of extraordinary profits. As with Fannie and Freddie and the S&Ls before them, these risks turn into losses that the taxpayers must absorb.

That Washington has not learned this simple lesson is shown by the proposal--supported by both Fed chairman Bernanke and Treasury Secretary Paulson--to put investment banks under the supervisory wing of the Fed. There you go again, as Ronald Reagan would say. This will remake the swashbuckling investment banks--inveterate and successful risk-takers--into incipient Fannies and Freddies, gambling with taxpayer money and growing flush with the lack of market discipline.

Not to worry, we will be told. The Fed will be on watch. Is this not the same Fed that--together with its brother bank regulators--allowed the heavily regulated banks to fail in underwriting subprime loans and set up off-balance-sheet investment vehicles? Washington is a strange place; every time regulation fails, Congress gives us more of it.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.