Arthur F. Burns Fellow Peter J. Wallison

Henry Paulson's plan is a major disappointment.

Although it was certainly necessary to bail out ailing mortgage giants Fannie Mae and Freddie Mac, the plan put forward by the treasury secretary this weekend prioritizes steering them back to financial health and defers into the future what is to become of the companies.

What's worse, after blaming the collapse of the companies on a "flawed business model," the plan will preserve that model indefinitely, allowing the shareholders of what are now insolvent entities to recover some value.

Long after Paulson is gone from the Treasury, Washington will be wrestling with the problem of what to do about Fannie and Freddie. And if the two companies are eventually nationalized, privatized or liquidated, the government--meaning taxpayers--will have to compensate the existing shareholders in some way.

The plan is relatively simple, but its implications for the future are troubling. First, Fannie and Freddie will be put under government control in an arrangement called a conservatorship. The purpose of a conservatorship is, essentially, to keep things as they are.

A conservator does not have the power to make any significant changes to the business model of a company; rather, its focus is to guide the company back to stability. Why anyone would sustain what Paulson himself called a flawed business model is hard to understand.

It gets worse. Under the plan, the Treasury is committed to providing equity capital to Fannie and Freddie. Another puzzle: Why is it necessary to inject taxpayer funds into these companies as equity? Ordinary companies need capital so that they can meet their obligations, but both these companies will have access to a financial facility at the Treasury that will allow them to borrow all the funds they require.

They don't need capital. The injection of capital is, in fact, a gift to the existing shareholders, who--as the owners of insolvent companies--own nothing and deserve no benefits from the taxpayers. By injecting these taxpayer funds and enabling the companies to survive, the Treasury plan opens the possibility that the existing shareholders will eventually profit from their investments, when, by all rights, they should be wiped out.

The nature of this gift is further emphasized by the fact that the Treasury is taking warrants for its agreement to finance these companies. These warrants will only be worth something--and thereby allow the Treasury to compensate the taxpayers--if the companies are nursed back to financial health under the conservatorship. So the government has created an incentive for itself to keep the companies alive and restore their well-being.

Once that occurs, the current shareholders will again be able to reap the benefits of holding interests in government-sponsored enterprises (GSEs)--only in this case, the two companies will not be implicitly backed by the government; they will be explicitly backed. In that case, the shareholders and the managements will once more profit from the government backing, while the taxpayers will still be the ones taking the losses.

There was an alternative, one that was simpler and much more sensible from a policy perspective. Since Fannie and Freddie operated under this "flawed business model"--by which Paulson probably meant government backing for shareholder-owned companies, the essence of a GSE--the plan should have set things in motion for the elimination of this model.

Instead of a conservatorship, the plan should have provided for a receivership. That system would get rid of the common stockholders while still monitoring the companies for an indefinite period in order to keep the mortgage market functioning smoothly.

Thus, while Paulson's plan was intended to provide some "breathing room" for consideration of the companies' future, what it will do in effect is restore them to health as government-sponsored enterprises, and, more critically, allow them and their newly empowered shareholders to bargain about the companies' collective future from a position of strength.

No wonder U.S. Sen. Charles Schumer of New York--probably the GSEs' most ardent supporter in Congress--issued the following statement after Paulson addressed the press on Sunday: "This plan will be met with broad acceptance in Congress, because it doesn't prejudge the ultimate fate of Fannie Mae and Freddie Mac.'' Translation: Prepare for a fight--because we intend to keep the GSEs alive.

Republican presidential candidate John McCain has been campaigning against the culture of corruption in the federal government. Democratic presidential candidate Barack Obama has based his campaign on the idea of change in Washington. Fannie Mae and Freddie Mac are telling illustrations of corporate welfare--the profitable private exploitation of a cozy relationship with the government. And the Paulson plan will foster just what a cynic might expect: more of the same.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.