Fears about what would happen if Fannie Mae and Freddie Mac went broke have submerged a more fundamental question: Is the existence of Fannie and Freddie good for our nation?
The immediate concerns are not trivial. The fear is that if the U.S. doesn’t help these beleaguered government-sponsored enterprises, they will go broke, touching off an implosion of financial markets on the order of what happened from 1929-1933. Even the chance of such a catastrophe looms large enough that few elected or appointed officials are willing to take the risk.
So we are planning on giving Fannie and Freddie access to loans from the Federal Reserve usually available only to commercial banks that the Fed regulates. We are making an implicit Treasury guarantee of Fannie and Freddie’s bonds explicit. We are saying the federal government will do “whatever it takes” to avoid their failure, including buying their stock and making their debt part of the national debt.
All of this creates terrible incentives in the short run and bad precedent for the longer run. How did we get into this mess?
The Federal National Mortgage Association was formed during Franklin Roosevelt’s administration as a response to the housing crisis of the 1930s. Most home mortgages then were five-year loans made by local banks that required a substantial down payment. The loans had balloon payments at the end of their terms. In effect, this system was one of five-year rolling refinancings.
Millions of families lost their houses in the Depression that might have held on to them if they had longer-term mortgages. Thousands of banks were unable to serve their good customers simply because there was no money available to make new mortgage loans.
It seemed that free markets were not working properly. The New Deal’s response was to create a government entity to solve the problem.
The new FNMA — now known as Fannie Mae — would sell bonds on Wall Street. The federal government guaranteed these bonds so FNMA could borrow large sums at low interest. It used this money to buy mortgages from banks. This meant the banks, in turn, could move an existing mortgage off their books and make another one.
The advent of government guarantees for mortgages themselves facilitated the process. By the 1950s, 30-year mortgages became common.
It seemed a great success. In 1968, largely to get its debts and assets off of the federal balance sheet, FNMA was converted from a government agency into a publicly held corporation traded on the New York Stock Exchange.
Critics noted the new structure created a “heads the shareholders win, tails the taxpayers lose” situation. The government countered it did not guarantee Fannie’s debts in any way. But private investors and politicians assumed that when push came to shove, the government would back it up. As ongoing events demonstrate, the critics were right.
Fannie and its partner government-sponsored enterprises, or GSEs, such as Freddie Mac, retain special privileges. They have looser capital requirements than other financial institutions. They are exempt from state and local taxes. They are exempt from many Securities and Exchange Commission filing requirements. The list goes on.
This special treatment is worth a lot. Back in 1996, the Congressional Budget Office estimated the value of special government treatment of GSEs at about $7 billion a year.
In recent years, critics such as William Poole, until recently president of the St. Louis Fed, noted the GSEs were using their accounting-rule exemptions to take on risky, high-return investments. This did not meet any national housing need, but simply exploited their special status to increase shareholder returns.
When criticized, Fannie and Freddie plead their indispensability: “We have half of the $12 trillion in U.S. home mortgages. Treat us nice or the economy will swoon. Everyone will pay higher interest on their mortgages if we get treated like other private financial firms.”
This is somewhat like the kid who killed her parents and then begged for mercy because she was an orphan. Fannie and Freddie have such a large share of all mortgages because the special privileges they enjoy make it very difficult for any truly private firm to compete with them.
Special government-granted monopoly privileges inevitably engender abuses. It may well be better to bail out the GSEs now than to risk the consequences. But it would be a severe mistake to return them to their earlier status quo.
The abuses of the securitization of subprime mortgages aside, the past 25 years demonstrate that private financial firms can marshal private capital into long-term home mortgages. Securitization, properly regulated, can work and can accomplish everything the GSEs do with greater public benefit and at less taxpayer risk.
Inertia and political behavior favor the status quo. Congress reacts to government-engendered financial debacles like people do when someone gets sick on a bus. The instinctive reaction is to cover up the mess and then edge away, hoping others will do the unpleasant cleanup. It would be a mistake to let that happen this time.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.