Regime Uncertainty Exemplified in the Fannie/Freddie Debacle

The February issue of Vanity Fair has an interesting article on the politicking associated with the Fannie/Freddie debacle. Toward the end of the story (p. 146), the author, Bethany McLean, describes a late-stage episode in this tale that nicely exemplifies the concept of regime uncertainty. I proposed the idea of regime uncertainty in a 1997 article about the extraordinary duration of the Great Depression. I argued there that the Roosevelt administration’s overt hostility toward investors as a class, especially after 1935, created fears about the security of private property rights and, indeed, about whether the economy would continue to be based on such rights or, instead, would be subjected to some species of collectivist takeover or dictatorship. The idea of regime uncertainty, however, may also be applied in many other contexts where the same kind of uncertainty tends to paralyze long-term investors, as it did in the latter half of the 1930s.

McLean relates how “on July 13, [Treasury Secretary Henry] Paulson announced a plan under which Treasury would backstop all of the G.S.E.’s debt and buy equity if needed. ‘If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out,’ Paulson told lawmakers.” Paulson’s plan was enacted into law shortly afterward. But, as Robert Burns’s poem warns us, “The best laid schemes o’ mice an’ men / Gang aft a-gley.”

Paulson’s bazooka to help Fannie and Freddie failed. . . . Investors were unsure what their eventual losses would be. Both companies announced terrible 2008 second-quarter results, with Fannie losing $2.3 billion and Freddie losing $821 million. But investors were also unsure what the new legislation meant. No one wanted to risk putting money into the G.S.E.’s, only to have the government radically raise capital requirements—or step in and wipe the shareholders out. And so, as if the second-quarter results hadn’t caused enough alarm on their own, the legislation had the perverse effect of ensuring the companies would be unable to raise new capital, even as everyone began to say that they had to do so.

For the past six months or more, the entire U.S. economy has been subject to increasing regime uncertainty, as the government has adopted, almost daily, gigantic new schemes to subsidize, bail out, prop up, take over, recapitalize, guarantee, stimulate, or otherwise interfere with formerly private enterprises, markets, and other arrangements. It seems likely that the recession’s continued worsening may be attributed in substantial part to the regime uncertainty the government’s frantic actions have created, and bid fair to continue creating. When private parties need reassurance the most, the government continues only to roil the waters.

H.T. Elizabeth