“Some investors,” according to a New York Times headline today, say it is. But of course it isn’t. A bailout – whether in the form of government capital infusions or explicit guarantees of Fannie and Freddie debts – is a policy decision. A different decision could be made.

A reasonable alternative would be for the feds to adopt the “structured early intervention and resolution” approach that the FDIC is supposed to apply to any bank whose capital becomes too low. If Fannie and Freddie have implicit taxpayer guarantees – if the Treasury is not prepared to see their bondholders take losses even should the firms become insolvent – then SEIR seems as appropriate for them as for FDIC-guaranteed commercial banks. SEIR requires any insured institution whose capital falls below a specified threshold (say 6%) to replenish its capital. Fannie and Freddie appear to be already below any reasonable threshold for a taxpayer-guaranteed institution. At some lower threshold (say 4%), oust senior management and restrict dividend payments. If capital continues to fall, close the institution before its net worth reaches zero so that its debt-holders and the taxpayers are protected. The time to begin applying this approach, if it is to be applied, is now.

Alternatively, if the Treasury is prepared to see Fannie and Freddie bondholders take haircuts, the feds should declare either institution bankrupt when its measured net worth, based on marking its assets to market, reaches the point where its portfolio could be liquidated for just enough to repay its debtholders. Some say that Freddie’s net worth is already below that point.

The market appears to believe that Fannie and Freddie do have implicit taxpayer guarantees. The NY Times reports:

Government officials note that both companies continue to buy mortgages and that they are borrowing at rates far below what other banks and companies pay.

The lower borrowing rates can only be the result of lenders counting on a bailout should Fannie or Freddie be unable to repay fully otherwise. The lower borrowing rates are, of course, what have allowed the two firms to grow so much larger than any other financial intermediaries. The implicit guarantees themselves have led to "too big to fail" institutions that supposedly make a bailout upholding the implicit guarantees "inevitable". A self-justifying intervention into the market!

What would be the spillover effects of liquidating Fannie or Freddie? We can't completely know. But recall that liquidating a bankrupt airline does not make its airplanes or pilots disappear. The planes and pilots are instead reallocated to airlines that can use them to fly passengers more efficiently. Liquidating Fannie or Freddie would likewise reallocate its assets and personnel to other institutions that can intermediate efficiently – without taxpayer guarantees.

The more talk I hear about a bailout being inevitable, the more I am convinced that liquidating Fannie and Freddie and starting afresh with explicitly unguaranteed institutions is the only credible way to reach the goal of an undistorted financial market populated by institutions that do not threaten to unload their losses on taxpayers. How best to liquidate Freddie or Fannie if they become near-insolvent should be the topic now under discussion -- not how best to bail them out.