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With the ballooning sub-prime crisis during 2007-2008 many home-owners defaulted in their payments causing Freddie and Fannie to suffer multi-billion dollar losses. The share prices tumbled by more than 90% and the investors around the world felt that these two firms
might not have the money to make good their guarantees. The regulators took several steps to help the firms, and in July, steps were taken to provide them access to federal money. In spite of all this, the shares kept plummeting.

As a result, on 7th September, the Federal Housing Finance Agency announced taking over these firms, putting them under conservatorship, and making the tax-payer backing explicit. Without this rescue, a much larger rescue might have been at hand with the banking system requiring a bail-out. Also with Fannie and Freddie out of the market, the mortgage-based finance would have virtually came to an end, causing housing rates to plummet further, thus, having a spiraling effect.

But this kind of rescue is also associated with some major problems. One major concern with these huge bail-outs of the companies in times of financial disaster is the creation of a "Moral Hazard" scenario. These may affect the companies in terms of poor management, weak leadership by setting-up bad precedents for future. An efficient organization is expected to take decisions based on well-evaluated risks and more importantly should have a Plan B ready, in case things don't go the expected way. This new option of Government bail-out can alter the way businesses run.

The bail-outs are necessary and some may argue that Government is not helping out every organization (Lehmann stands a tall example). But it won't need a rocket science to guess what all banks stand a fair chance of government's help. A quasi-public private organization, such as Freddie Mac and Fannie Mae, which were brought into existence by the Government itself for working out loans, will always be in safer hands.

More than the bail-out, a complete re-vamp of the financial system is needed for the long-term benefit of the country's economy and the tax-paying citizens. A detailed study needs to be carried out for the reason behind the failure and changes that need to be brought in. Bail-out will always be a step to overcome the failure in a short span, and the Government won't be helping out for years, especially when the crisis is this huge.

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* Contributed by: -
Madhav Sharma had been a Marine Engineer by profession while Sumit Singh had been a Software Engineer before they joined Ist Year Full-Time MBA at NMIMS, Mumbai.
Article posted on October 11, 2008.