Rethinking Fannie and Freddie's New Insolvency Regime

Faced with the potential collapse of mortgage giants Fannie Mae and Freddie Mac, Congress created a new insolvency regime for these government-sponsored entities based on the procedure applied to failing federal banks. This Note argues that this new insolvency regime will create unne cessary taxpayer exposure to financial risk without preventing a similar problem from recurring, unless the implicit federal guarantee of Fannie Mae and Freddie Mac more closely mirrors the explicit federal guarantee of bank deposits. The Note begins by identifying three essential elements for an effective insolvency regime. First, creating such a regime is only appropriate to address a substantial societal concern that private ordering cannot solve. Second, the government should provide explicit, federal backing targeted specifically to solving that social problem. Recognizing that a federal guarantee may create a moral hazard, the third essential element is establishing a mechanism to ensure the limited federal backing does not expand to an undefined guarantee of the entire entity. Applying this model to the secondary mortgage market, this Note proposes the creation of a Covered Bond Insurance Corporation (CBIC), modeled after the Federal Deposit Insurance Corporation, that will explicitly provide mortgage insurance to entities that issue covered bonds. This solution would facilitate a liquid secondary mortgage market, while ensuring taxpayers’ potential liabilities remain limited, thereby mirroring the federal guarantee provided to banks.