Saturday, February 12, 2011

The Future of Fannie and Freddie

Back in the early 1960s, Fannie Mae was a government agency, and had been so since it was created as part of the New Deal. Lyndon Johnson took it private to raise funds for the Vietnam War. In the intervening years, most commentators seem to have forgotten that history — and that the recent implicit government guarantee of Fannie Mae securities has been a carry-over from the explicit government guarantee that was there pre-privatization.

Today, Fannie Mae and it's near relation Freddie Mac are owned by the government again. Obama, along with most other government leaders who have drunk the Kool-Aid of free market miracle cures, can't wait to take it private again — or, better yet, eliminate Fannie and Freddie altogether. The basic idea, albeit offered as three separate "alternatives," is to make these big mortgage securitization houses less and less competitive until they disappear.

I cannot disagree that the mortgage giants' standards became entirely too lax when it came to deciding which loans would be purchased for securitization. The reason for that laxity, though, was that they were private companies, and had slipped the harness of government regulation thanks to free-market deregulatory fever. Their executives collected vast bonuses based on the amount of business they were able to churn, so riskier loans helped pad their pockets. Shareholders pressured those executives to increase earnings enough to remain "competitive" with finance houses like Lehman Brothers. There was nobody to say "no" when Fannie and Freddie took on vast amounts of irrational risk.

To me, the best thing to do from this point on is for the government to keep Fannie and Freddie, as federal agencies, with the goal of eventually earning back the money spent on their bailout. As federal agencies — better yet, as a single combined Agency — Fannie/Freddie could be operated according to succinct rules, with no need to pander to the greed of Wall Street oriented directors or the pressures applied by shareholders. Think about it:
  • A specific rule could limit the size of a mortgage the Agency could purchase. Reducing the maximum amount to $400,000 seems in line with the goal of helping the middle and working classes afford housing.
  • A specific rule could specify the percentages that must be paid in down payments to qualify a loan for purchase by the Agency, with lower interest rates available for those paying 20% or more, and a minimum down payment of 10% limited to smaller loans designed for the less affluent. Such a rule would reduce and offset possible defaults.
  • If the rules are clearly and precisely defined, "talent" is not necessary among the agency's directors. Bureaucrats, on specific salaries with no bonuses, would fill the bill.
  • The Agency would remain competitive with the private sector because an explicit government guarantee of the securities it issued would allow it to offer lower interest rates than the banking industry. Agency profits usually would not be as great as those generated by private financial firms, but they would be far less volatile.
Without Fannie/Freddie, it seems very certain the 30-year fixed-rate mortgage will wither and die. No private banker will be willing to tie up funds for more than ten to fifteen years at a fixed rate — with no ability to predict the kinds of rates that might prevail in the future. That uncertainty would make shorter term fixed rate mortgages more expensive as well. Without the 30-year mortgage, prospective homeowners would have to wait and save for many years before even thinking of buying a home, and many would wait forever because their incomes never would grow to a size sufficient to pay off a ten- or fifteen-year loan.

If mortgages are difficult or impossible to obtain or afford, demand for existing housing stock will plummet, and so will real estate prices. For the many middle class families whose homes are their most significant reservoir of wealth, the effect will be devastating.

Yes, Fannie and Freddie are seriously flawed — but the flaws emerge from their "hybrid" status. As purely government entities, they can operate successfully and continue to fulfill their original purpose. They can be designed to be moderately profitable or just to break even, depending on will of (a mostly imaginary) Congress. The only reasons to end their existence by complete privatization are ideological rather than practical. Our economy already has been hamstrung by the ideology of the so-called "free market." It's time to take a new look at the true successes of the New Deal.

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