Off guard saviour

Equity markets across Asia and Europe have started the week with massive gains. The reason is this weekend's news according to which the US government has agreed to a Fannie Mae and Freddie Mac bailout. In fact, the Treasury is nationalizing both. The companies' executives have been ousted and replaced by government appointed people. The move comes on the heels of speculation about the lack of long term financial sustainability at both institutions, heavily hit by the subprime debacle. Albeit late, I believe the US government has done the right thing because "Fannie and Freddie are just part of the American way of life" as a well known hedge fund manager, Barton Biggs, put it quite recently. Allowing them to fail would have put the US economy, and frankly the whole american society, at jeopardy. However, what can we learn out of this?

Two things. First, lending to people with poor credit records is not a good idea. Second, financial innovation is a dangerous thing if left exclusively in the hands of the innovators. In other words, if regulators are going to allow billions of dollars worth of asset backed securities into banks' balance sheets, they ought to know how these instruments work, what are their underlying assets and how issuers price them. The subprime debacle has been yet another demonstration of how badly Over-The-Counter markets work if left alone in extreme situations. Had these instruments been trading like a regular Dow Jones stock, and they would have been adequately priced. None of this would have happened. Indeed, liquidity concerns regarding the ability to effectively price and trade some of these intruments, would have prevented the public placement of most of them. But of course that wouldn't have had allowed for subprime lending in the first place, because banks wouldn't take on the extra risk unless they could transfer it afterwards.

This outcome will likely restore some confidence among investors and households. Especially, if the Fed and Treasury, recently off guard, take some time to think about ways to discipline banks, their lending practices and, above all, the way these players price and trade illiquid and inflated assets among themselves. A free ride for banking executives and stakeholders because banks cannot be allowed to fail. But eventually putting everyone else at risk and hoping for the ultimate saviour - government - to come in for the rescue. Unfortunately, at the cost of tax payers.