Fannie Mae and Freddie Mac Should Be Cut Down and Cut Loose

This article appeared in U.S. News & World Report on July 21, 2008.

Why should Fannie Mae and Freddie Mac enjoy special tax and regulatory privileges unavailable to other publicly traded corporations? Why should U.S. taxpayers be required to lend them money, or pick up the tab if they can't pay their bills?

The answer of course is that Fannie and Freddie should get no such privileges and taxpayers should not have to protect them.

Fannie and Freddie are specially privileged "government-sponsored enterprises." They're exempt from state and local taxes. And their required "core capital" (mainly stock) is merely 2.5 percent of assets, compared with a 6 to 8 percent norm for banks. As a result, their $5.3 trillion of debt is piled precariously atop a thin cushion of only $81 billion in core capital. It's risky business. But who bears the risk?

Fannie and Freddie pay an artificially low interest rate on their bonds because everyone assumes that, if it came to it, the U.S. Treasury would bail them out. The artificially fat spread between interest rates earned on mortgages and interest rates paid on bonds amounts to a big subsidy. That thwarts competition. It also undermines market discipline, because creditors have little incentive to monitor the firms' borrowing and investments.

Another unique privilege has been a $2.5 billion line of credit with the U.S. Treasury. Not enough? Treasury Secretary Henry Paulson recently proposed offering Fannie and Freddie unlimited access to the U.S. Treasury for 18 months. He invoked the old "confidence" game, claiming a blank check on the U.S. Treasury "is the best means of increasing market confidence" in Fannie and Freddie. The idea also proved to be an excellent means of decreasing confidence in U.S. Treasury bonds and the dollar, both of which lost value on the news.

Contrary to a common misimpression, Fannie and Freddie provide no mortgages. They just buy bundles of mortgages from lenders and swap them for mortgage-backed securities. They also invest in private mortgage-backed securities, paying for them by getting deeper in debt.

What they own or guarantee amounts to 42 percent of all mortgages, but we know from recent experience that, if Freddie and Fannie bought less, other institutions and investors (including pension funds) would simply get a bigger share. Fannie and Freddie were involved in scandalous accounting fraud in 2003, manipulating earnings to boost their executives' pay. The Office of Federal Housing Enterprise Oversight reacted by raising their capital requirement, greatly limiting their capacity to grow. Yet that certainly didn't make mortgages scarce from 2004 to 2006.

The greater the failure of government regulation, the greater the political urge to give regulators more power and money. But regulators have no magical power to anticipate unforeseen problems, and no incentive to put sound economics ahead of short-term politics.

Secretary Paulson dreams of "a new world-class regulator" for the troubled enterprises. Their current regulator, the Office of Federal Housing Enterprise Oversight is apparently too old at age 16 and not "world class." But regulation of Fannie and Freddie has always been heavily politicized, and there is no reason to expect that to change under a new entity. While Congress controls the oversight office's annual budget, Fannie and Freddie are famously generous with campaign contributions, giving them critical sway over their regulator's regulators.

In a properly critical survey of the economic evidence about Fannie and Freddie, W. Scott Frame of the Atlanta Fed and Lawrence J. White of New York University concluded the best solution would be to end both the special privileges of Fannie and Freddie and the accompanying legal restrictions on the diversity of their investments. Among second-best solutions, they suggested the opposite of Treasury Secretary Paulson's proposal—namely that top officials should explicitly state the government will not guarantee Fannie's and Freddie's debts. They also suggested the opposite of congressional legislation—that the maximum sizes of mortgages the enterprises buy should be frozen rather than increased in order to focus support on less affluent homebuyers.

They are correct, but such good economic advice is too often trumped by politics. A new regulator is unlikely to be any better than the old regulator because the whole notion of a government-sponsored business is thoroughly politicized and inherently corrupt.

Fannie and Freddie may be "too big to fail," but that means they are also too big for taxpayer bailouts.

Potentially massive loans from the Treasury and Fed are no solution to their already excessive debt—the last thing they need is more. These two politically privileged companies pose a "systemic risk" to the economy precisely because they became much too big in the past two decades. Any serious solution must begin by requiring Fannie and Freddie to do what other troubled firms are routinely required to do—sell assets, raise capital, and reduce debt.

Fannie Mae and Freddie Mac need to be downsized and de-leveraged, relieved of special privileges and loan guarantees, and broken into small pieces agile enough to sink or swim on their own, without taxpayer support.