Optimality of Government Sponsored Entities, Fannie Mae and Freddie Mac

The U.S. Congress held a hearing on December 9, 2008 with experts and ex-GSE executives. Those who advocated elimination of the existing government-sponsor charter of GSEs stated that the government guarantee causes moral hazard due to excessive risk taking. But this logic should also lead to a conclusion that to preclude moral hazard risk the existing charter of commercial banks and investment banks - that hold federally insured deposits and are considered too big to fail - should be eliminated. This would mean that the government should give no explicit or implicit guarantee to any financial institution because such guarantees lead to moral hazard risk and excessive risk taking. This argument is consistent with the current paradigm of maximization of utility of a representative agent, not the new paradigm of prosperity amid stability for democratic capitalism.

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