Blog Post

The Future of Fannie and Freddy

What’s at stake: The housing market is going through such an existential change that the very institutions that are at its heart need reforming. In particular, the role of Fannie Mae and Freddie Mac – the two government-sponsored enterprises (GSEs) that support the secondary mortgage market – which lied at the heart of the democratisation […]

By: Date: October 28, 2010 Topic: Banking and capital markets

What’s at stake: The housing market is going through such an existential change that the very institutions that are at its heart need reforming. In particular, the role of Fannie Mae and Freddie Mac – the two government-sponsored enterprises (GSEs) that support the secondary mortgage market – which lied at the heart of the democratisation of US homeownership will need to be rethought. The Obama administration is expected to release a proposal to this effect in January with far reaching consequences for the housing market in the US.

Fannie Freddy … Guilty!

Mother Jones points that their original mandate was to promote homeownership by making a large pool of credit available at affordable rates. They accomplished this by buying up mortgage debt from banks and packaging it into bonds, allowing investors to get in on the action. Banks responded by lending out more money, and Fannie and Freddie’s combined mortgage portfolio exploded from $61 billion in 1980 to $1.2 trillion two decades later, according to the Government Accountability Office.

Peter Wallison of the American Enterprise Institute argues that government policies – and namely the presence of the GSEs – created the incentives for both a housing bubble and a reduction in the bank capital and home equity that could have mitigated its effects. To prevent a recurrence of this disaster, it would be far better to change the destructive government housing policies that brought us to this point than to enact a new regulatory regime that will hinder a quick recovery and obstruct future economic growth. This is also the line pushed by Raghu Rajan, whose book "Fault Lines" argues that government action to support housing markets was one of the major economic forces underlying the development of the crisis.

Karl Smith from Modeled Behaviour argues that although Fannie and Freddy are “creepy” and “unsavoury”, they didn’t cause the housing bubble as their involvement actually declined substantially from 2003 until the crisis erupted. Brad Delong shares this view. Although F&F’s essential mission of subsidising the American dream for low and moderate income families might be a fundamentally bad policy, it does not appear to be either the origin of the housing bubble or the source of Fannie and Freddie’s trouble. Paul Krugman has a nice graph to back up this claim.

Ryan Avent notes that one of the defences of Fannie and Freddie is that their involvement in mortgage markets trailed off in 2003, just as the housing party really got going. But a good question is why private lenders surged into the gap. Jim Hamilton points that it is reasonable to believe that private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

The cost to the US taxpayer

The FT argues that the rescue of Fannie and Freddie is shaping up to be one of the most expensive of recent bail-outs, exceeding the cost of the savings and loan crisis that saved small banks and thrifts in the 1980s and the Troubled Asset Relief Programme of 2008, which threw a lifeline to financial companies and carmakers. The article reports previous estimates of the cost to the taxpayer. Since they were rescued by the government in 2008, Fannie Mae and Freddie Mac have drawn $148bn from the US Treasury to stay afloat as losses on bad loans underwritten during the housing boom turned bad at a record pace. In August, the Congressional Budget Office said Fannie and Freddie would need $390bn in federal subsidies to the end of 2019. The White House’s Office of Management and Budget had in February estimated the cost to be as little as $160bn for the same period, providing the economy continued to strengthen. The Federal Housing Finance Agency, which regulates the two entities, said it was possible losses could be less than $363bn.

Richard Green argues that the Fannie-Freddie problem is not as severe as suggested. The Federal Housing Finance Agency report gives forward expected losses under three scenarios.  The third is really awful, but assumes a further reduction in house prices by 1/4, which would be a lot.  But under the other two scenarios, the net cost to taxpayers would be $6 to 19 billion.  This is real money, but hardly cataclysmic.  It does suggest that the vast majority of the losses are already behind us.

The Future of Freddie and Fannie

The Economist asked the question to a group of economists. It concludes that so far, there is some (but not universal) agreement on principles but little consensus on strategy. Laurence Kotlikoff and Phillip Swagel each have plans to make Fannie and Freddie true private firms. Tom Gallagher suggests they should be returned to their pre-Johnson administration status, while Mark Thoma suggests that moral hazard could be reined in through new regulation and John Makin argues simply that they should go away.

Edward Glaeser argues that the only future for Fanny and Freddy is to end the ambiguity that lies with the Treasury’s guarantee and become fully public institutions focusing on one task and guarantee 30y fixed rate mortgage and charge a high premium to stay solvent until the private sector through competition puts it out of business. This doesn’t require a profit motive but rather prudence. Such prudence is far more compatible with a slow-moving public bureaucracy than with a nimble, profit-seeking private company. The job of the entity should not be expanded to include holding a vast portfolio of mortgages, providing affordable housing for the poor or stability for the financial system. There are other, better instruments to promote housing affordability, like Section 8 housing vouchers and the Federal Housing Administration. The Federal Reserve System, the Federal Deposit Insurance Corporation and the Treasury are far better positioned to protect the financial system. Multiplying an institution’s job creates the risk of it failing on all of them.

Former St. Louis Fed President William Poole argues that the danger in having any new mortgage agency is that its guarantees would subsidize mortgage risk, eventually leading to further taxpayer losses. The only sure way to prevent that outcome is to phase out Fannie and Freddie. If the home finance market were fully private, then it would bear the losses from its own mistakes in pricing and insurance. The proper government role is regulatory oversight and not direct operation of financial firms. A sensible transition plan would have them stop buying new mortgages, and their portfolios would decline as the mortgages they own are paid down. Their securitization business, whereby they purchase mortgages and issue securities against them, should likewise be wound down. A practical approach would be to set a gradually rising schedule of fees, motivating private companies to enter the securitization business.


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