Social & Domestic Issues

Fannie Mae and Freddie Mac Plan Yet Another House of Cards

With a $154 billion bailout of Fannie Mae and Freddie Mac thus far, and regulators estimating the need for billions more, lawmakers in Washington have finally begun debate on how to wind down these two failed mortgage giants.  While there is widespread agreement that they must be eliminated gradually to avoid market disruptions, plans for what will replace Fannie and Freddie have not found similar consensus.
 
One plan has recently gained attention on Capitol Hill, not the least because it has emerged from a surprising source.  In early May the typically small-government conservative Rep. John Campbell (R.-Calif.) teamed up with Rep. Gary Peters (D.-Mich.) to introduce the Housing Finance Reform Act, HR 1859, mirroring an Obama administration proposal released earlier this year.  Campbell apparently believes that Fannie and Freddie simply provided the wrong kind of government support for the housing market, not that government support itself was the problem.  Campbell’s mind-set is reminiscent of Friedrich Hayek’s book on the failure of socialism The Fatal Conceit.  If we could just get the right kind of government support in place, we could continue to subsidize low mortgage rates and the 30-year fixed-rate mortgage while simultaneously protecting taxpayers from the risk of future bailouts.
 
This time, it will be different, he says.  This time the government’s guarantee to mortgage investors would be explicit, and significant layers of private capital would stand as a buffer before taxpayer funds are used to prop up the market.  Should losses occur on soured mortgages, taxpayers would chip in only after homeowners’ equity and the security issuers’ shareholders are completely wiped out and a special Federal Deposit Insurance Corporation (FDIC)-like reserve fund is entirely depleted.  By building strong buffers and with careful regulation, taxpayers are sure to be safe, right?
 
Don’t be fooled.  Campbell’s plan strays far from limited-government principles, simply replacing the failed Fannie Mae and Freddie Mac model with another form of government support, once again putting taxpayer dollars at risk to subsidize mortgages and protect investors from mortgage-related losses.  Joining a growing chorus of critics, American Enterprise Institute scholar Alex Pollock explained the flaw in this plan at a recent hearing:
 
“Remember that this theory of having private capital in front of government risk was exactly the theory of Fannie Mae and Freddie Mac, and in the 1990s, when their risk-based capital was set up, the theory was that this risk-based capital would allow them to survive a new Depression.  Obviously it was all wrong.” 
 
We’ve seen in the past that when government is running the show, prudential management typically gives way to political pressures.  In the years leading up to the financial crisis, Congress relaxed or simply didn’t enforce Fannie’s and Freddie’s capital standards, leaving the GSEs (government-sponsored-enterprises) more highly leveraged than their private market competitors.  They then blew through their razor-thin capital buffers at an alarming pace as the housing bubble collapsed, with the disastrous results that we’ve seen today ($154 billion in bailouts and counting…).
 
Reserve funds have also proved to be an unreliable tool, because they tend to be either raided by Congress for other big-government spending projects (as the Social Security Trust Fund has been) or poorly managed (as the recent experience with the FDIC’s Deposit Insurance Fund shows).  Congress also has strong incentives to reduce the government’s “guarantee fees” in order to hold down mortgage rates, thereby underpricing risk in government-backed mortgage investments and underfunding the reserve fund presumably in place to protect taxpayers.
 
In short, as long as Congress has an interest in keeping mortgage rates low for the homeowners in their districts, they will not be able to resist the temptation to undermine taxpayer protection in the name of affordable housing.
 
But even if Campbell is right, and all of these protections work precisely as he predicts, he has still forgotten the most important point.  If the guarantee associations (first), the reserve fund (second) and taxpayers (third) pick up the tab for any credit losses, when do the investors in the securities, those who ultimately fund mortgage loans and stand to profit from them, ever have to face losses?  And if investors can’t lose, what incentive do they have to choose their mortgage investments carefully?  With no market discipline imposed by the prospect of facing real losses, moral hazard would run rampant.  The result would be severely underpriced risk (more risky loans), overinvestment in housing (another housing bubble), and a misallocation of capital (diverting funds from other, more productive sectors of the economy).
 
Campbell has tried to build a regular Fort Knox to protect taxpayers from losses, but even these protections are likely to fail.  The reason is that it doesn’t matter how many walls you put up if taxpayers, instead of securities investors, are the ones having their pockets raided at the end of the day.  Until private investors are the ones bearing the losses on any shoddy investments they make, the very same problems that spurred the recent financial crisis will remain locked in place, and taxpayers will remain on the hook for bailouts running into the billions of dollars.

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  • Guest

    HOUSE OF CARDS?
     
    Ha-Ha—It has collapsed, and most people don’t know it, maybe they need to be officially told by the President of the USA, in order for them to RUN for their financial lives.
     
    Why do you think that the BofA stock is dropping like a rock, over 1/2 trillion dollars worth of homes that are under water and not performing. Chase and Wells Fargo, not far behind.
     
    As for Fannie and Freddie, over 2 trillion dollars worth of homes, that ownership cannot be verified. Send them a respa letter, asking for verification of ownership, and also ask them to make a minor decision, and No-Go, they are frozen, and will stupidly ask you to contact their “servicer”, to make that decision for them.
     
    Well, when the “major banks”, the gang of six, are required to accurately give their “assets” a real value, you will see six banks under water, themselves. As for Fannie and Freddie, the chickens have come home to roost. By the way, they have over 2 trillion dollars of homes under water and not performing.
     
    CAN YOU SAY TIMBEEEERR!