Brad DeLong writes,

If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?

With all due respect to Brad, this is a horrible, horrible idea.

Granted, it appears that the market loves Treasuries and hates mortgage-backed securities (MBS), and this is causing a lot of indigestion on Wall Street. But tasking Fannie with making a big bet on MBS would be an extreme example of privatizing profits and socializing losses.

If the bet pays off, Fannie Mae shareholders will take the profits. If the bet goes bad, taxpayers will take the hit.

I would rather see the Fed make the bet on MBS. If there is a profit opportunity in shorting Treasuries and buying MBS, then the Fed is in a great position to take advantage of it. The Fed has lots of Treasuries on its balance sheet that it can swap for MBS.

Those of us who think that the spread between MBS and Treasuries is an anomaly should be careful, however. The spread consists of both anomaly and option value. A mortgage has two valuable options–a prepayment option and a default option. The lender is short both of those options, which explains why MBS ought to have a higher rate than Treasuries.

The default option becomes more valuable as house prices become more volatile, which they have. The prepayment option becomes more valuable as interest rates become more volatile, which they have.

Finally, our political leaders in their infinite wisdom have added a third option, which is “neither pay your mortgage nor default, but instead wait for us to come up with a ‘plan’ to reduce your interest rate, your loan balance, or both.” This “play-the-victim” option is yet another legitimate reason for the MBS-Treasury spread to be wider than it has been in twenty years.

I continue to be a liquidationist. Get the unqualified borrowers out of their houses, and let the underlying housing market start to function.