Time for Fannie, Freddie to go

Diagnosis is often much simpler than treatment. The failures of Fannie Mae and Freddie Mac, America's housing-finance giants, are glaringly obvious. The two firms, which own or guarantee more than half of the country's $10.7 trillion of mortgages, are awash in red ink.

The Congressional Budget Office reckoned in August 2009 the twosome's cost to taxpayers could go as high as $400 billion. With housing showing renewed weakness, that number may rise.

It is also easy to see why the firms got into such a mess. These "government-sponsored enterprises" (GSEs) occupied a grey area between state and private ownership, benefiting from an implicit government guarantee on their own debt at the same time as they sought to maximize profits for shareholders.

That hybrid model granted the GSEs access to cheap funding and gave them the incentive to load their retained portfolios with subprime mortgages while maintaining capital levels scanty enough to make investment banks blush.

Although everybody agrees on the need to overhaul Fannie and Freddie, nobody is rushing to do much about it.

America's thumping financial-reform bill, which was signed into law by Barack Obama on July 21, found room in its 2,319 pages to create "Offices of Minority and Women Inclusion" in various federal agencies, but did nothing on Fannie and Freddie.

The two were taken into "conservatorship," a form of government ownership, in 2008 and have been put to work ever since. Virtually the only mortgages investors will buy are those guaranteed by the GSEs and other federal agencies.

More than nine in every 10 new mortgages written in America during the first quarter of 2010 were government-backed. Policy-makers are horrified by this level of intervention and terrified about withdrawing it. The treasury says it will put out proposals on the future of Fannie and Freddie early next year but there are few signs that politicians are prepared to get rid of them altogether.

They should. The GSEs' mission is to provide "liquidity, stability and affordability" to America's mortgage market. Set aside the fact these aims tend to conflict: cheerleading for cheap mortgages is likely to produce instability, for example.

The bigger question is why Fannie and Freddie are needed to achieve them. America's obsession with home ownership is itself questionable, especially now that the trap of negative equity has hampered workers' ability to move in search of jobs.

Even if it were a valid goal, there are countries (Australia, Britain and Canada among them) that have similar or higher levels of home ownership with far less, and in some cases no, systemic government support.

As for liquidity, the argument America needs Fannie and Freddie because private securitization markets do not exist to take their place is circular.

The GSEs have guidelines for the types of home loans they can guarantee: these let Fannie and Freddie colonize the safest, "conforming" bits of the mortgage market (before expanding into dodgier bits), leaving private lenders to swerve around them into ever-riskier areas. If the GSEs were not there to securitize and guarantee prime American mortgages, private firms would take their place.

There is still the fear investors would flee the market in times of stress if they did not have a federal guarantee, implicit or otherwise. But other changes can sharply reduce that risk. Tighter underwriting standards would ensure originators of loans remain disciplined: Britain's plans for a more intrusive mortgage-lending regime provide one source of guidance.

Better loan disclosure would help investors in mortgage-backed securities to do their own homework rather than just relying on guarantees. Funding instruments such as covered bonds would give investors recourse to banks' balance sheets as well as the mortgages themselves in times of crisis.

None of this means it makes sense to get rid of Fannie and Freddie in one go. A gradual withdrawal is needed. The first step is to run off or sell their retained portfolios of mortgages. A second would be to squeeze the definitions of conforming mortgages over time, so that bit by bit, Fannie and Freddie lose control of chunks of the prime market.

American housing would, unfortunately, still have lots of props -- agencies such as the Federal Housing Administration and subsidies such as tax relief on mortgage interest. But the GSEs should go.

Republished from the Winnipeg Free Press print edition July 26, 2010 B5