Why Ben Bernanke’s Incomplete ‘Exit Strategy’ Could Lead to a Decade-Long Downturn

In last week’s “Semiannual Monetary Policy Report to the Congress“ and in his July 21 Wall Street Journal Op-Ed piece, Bernanke, the U.S. central bank chairman, laid out plans to wind down government credit extension programs and combat any potential inflationary pressures. What was not addressed was how - or even if - the two government-owned and operated de-facto hedge funds, with combined assets of more than $6 trillion, would be unwound, or whether they would remain in place as they are in order to be used as back-door fiscal and monetary policy tools.

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Propping up teetering banks may serve to shore up near-term public confidence in the financial system. But it also destroys the same system by dislocating any meaningful capital-allocation strategy by extending the life of sick institutions that suck up scarce resources. What’s happening at Fannie and Freddie is no different - except that it’s happening on an exponentially more debilitating scale.

As the buyer of last resort, the U.S. government is letting its two hedge funds continue to borrow and leverage themselves to backstop the nation’s mortgage-origination market. The Treasury Department also is buying up any mortgage-backed securities that Fannie and Freddie don’t add to their own balance sheets.

Taxpayers are being duped into believing that the mortgage market is recovering and that money will be flowing when they decide it is time to buy homes again.

But there’s a big problem here: At some economic “inflection point” - a point that will come together very quickly if interest rates unexpectedly spike - losses at the “twin terrors” of Fannie and Freddie could spike into the stratosphere, as well, meaning the financial reality that we’re detailing here will necessitate another bailout, but on a scale we’ve yet to envision.

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* * Bring Down the Curtain on Fannie and Freddie: It’s time to break up Fannie Mae and Freddie Mac. The government has proposed reducing their portfolios by about 10% per year, but that’s not happening. In an end-around maneuver, while Fannie and Freddie are being propped up and still growing, the government is buying mortgages through the Federal Reserve. Either way, taxpayers end up holding massive pools of mortgages that no one else wants. Doing away with the socialization of homeownership financing will put the market back in control of appropriating risk.