Jared Bernstein
Senior Economist
Economic Policy Institute

When you’re in the middle of a maelstrom, it’s hard to step back for a teaching moment.

The prospect of Fannie Mae and Freddie Mac failing is almost too unsettling to contemplate. As one investor told the New York Times, “If people lose faith in Fannie and Freddie, then the whole system freezes up, and nobody can buy a house, and the entire housing market can crash.”

We’re talking about a pair of institutions that hold or guarantee more than half of the nation’s mortgages.

In other words, they’re TBTF (too big to fail) and it’s a sure bet that we won’t let them go under. Treasury Secretary Henry Paulson apparently asserted today that the government is not planning an imminent bailout, by which he means that the government is busy planning an imminent bailout.

If you’re like me, you could use a short break from sweating bullets about all this. First, read Steve Pearlstein’s sage, measured take on this in today’s Washington Post. It’s easy for us to overreact at times like this and dig ourselves in deeper by being too heavy-handed with short-term fixes, like requiring all the banks with large write-offs to replenish their capital stocks right away. He concludes, “In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact.”

I’d amend this point. What matters most is that we learn a lot more about what went wrong and implement some fixes. Not necessarily today, as Pearlstein stresses, but soon. When it comes to financial markets, our modus operandi is starting to look like shampoo instructions: bubble, bust, repeat.

So here are a few random observations that came to my mind when contemplating the Fannie/Freddie potential meltdown in the context of the bigger picture.

-- Bubbles are much worse than we like to think, and we should work much harder to identify and prevent them. By “we” I mean, among others, the Federal Reserve, who, under Greenspan, had a fairly explicitly stated policy of waiting by the sidelines as the bubbles inflated, mops at the ready.

-- Overleveraging means undercapitalizing. See Fannie/Freddie/Bear Stearns and pretty much every hedge fund and investment bank that borrows short and lends long. I don’t really care if big banks play with fire, until I’m called upon to put the fire out. If you’re TBTF, then we must provide you with the necessary oversight to avoid charging a costly bailout to US taxpayers.

-- When derivatives are worth multiples more than the underlying value of the equity or bond from which their value is derived, that’s not a hedge. It’s a big, speculative bet and a recipe for greater volatility and risk ... risk which will typically be under-priced. I’m still working out the arithmetic on this one, but I pretty sure I’m right.

-- Speaking of pricing risk, yes, moral hazard is a big problem that contributes to the underpricing of risk (which, at some level, is the one factor behind all the bad stuff that’s happening now). But the time to worry about moral hazard is not the weekend when the big bank is failing. It’s years before, when you’re setting up the regulations under which the financial system can flourish without going off the rails.

BTW, on these points, I haven’t found a better set of ideas than those of Michael Lewitt, expressed here.

I could go on, but I’ve got to get back to biting my fingernails.

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Jared Bernstein is a senior economist at the Economic Policy Institute and the author of " Crunch: Why Do I Feel So Squeezed? (And Other Unsolved Economic Mysteries).”