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Too Big To Save: The Inherent Problems of Fannie...
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Essay by:Will Haun
Fannie Mae, the Federal National Mortgage Association, and her “partner,” the Federal Home Loan Mortgage Corporation, better known as Freddie Mac, have an enormous impact on the secondary mortgage market in the United States, owning or guaranteeing more than half of all U.S. mortgages valued at nearly $5.5 trillion (1). Their profound influence is not the result of successful economic competition however. Though traded on the New York Stock Exchange, Fannie and Freddie are recognized as “government sponsored entities” (GSE’s), enjoying government benefits not given to truly private-sector companies, making genuine competition with private-sector companies impossible.
The implicit government backing of Fannie and Freddie created a conflict between their private shareholders and U.S. taxpayers that proved fatal to the housing market in 2008 (2). But this conflict is not a recent development; it is inherent to the quasi-private, quasi-public nature of Fannie and Freddie as shareholders and taxpayers require two opposing forms of business governance. The risk-free lending rate offered by the U.S. government, while maximizing profits for shareholders and the political power of Fannie and Freddie for politicians, doesn’t offer the limits on risk taking needed to protect taxpayers (3). The danger of having two companies hold such a concentration of debt in one market is exacerbated when taxpayers become responsible for it. This conflict leads to precarious investments (such as those into the sub-prime mortgage market) without proper regulation, thanks to Fannie and Freddie’s considerable lobbying power (the two companies have paid over $170 million to lobbyists in the past ten years) (4). The inherent conflict between shareholders and taxpayers, as manifested through bad investments, implicit government backing, and politicized regulation, make the genuine privatization of Fannie Mae and Freddie Mac the one sensible solution to protect taxpayers. While the process of privatization has accompanying complications, no other solution can remedy the danger of companies that “gambled their way into financial catastrophe…through gains privatized and losses socialized.” (5)
In order to understand the inherent risk GSE’s provide to taxpayers, and more specifically, the inherent conflict between the shareholder and the taxpayer, it is necessary to provide a general outline of both the purpose of Fannie and Freddie, as well as the process by which they affect the housing market. Fannie Mae and Freddie Mac “are two government-chartered and government sponsored corporations that have been assigned the statutory mission of improving liquidity in the middle-class residential mortgage markets by buying and selling residential mortgages.” (6) It is important to note however that, unlike banks in the “primary mortgage market,” Fannie and Freddie operate in what’s known as the “secondary mortgage market. That is, they purchase mortgage loans from other sources…..you cannot [as a home buyer] obtain a mortgage directly from Freddie Mac or Fannie Mae.” (7) Rather, Fannie and Freddie combine mortgage loans by “securitizing” them in a mortgage pool of Mortgage-Backed Securities (MBS’s), which they can either sell to investors or keep. The danger however, “whether it retains or sells the security, the GSE [thus the taxpayer] bears the default risk of the mortgages.” (8)
Though taken off the government books in by the Johnson administration through a quasi-privatization effort in 1968, Fannie Mae and Freddie Mac still enjoy numerous advantages in government policy in order for their political purpose to be fulfilled. Lawrence White of the CATO Institute notes the many advantages afforded to Fannie Mae and Freddie Mac in “The Special Status of Fannie Mae, Freddie Mac, and the Consequences.” Due to space constraints, I have listed only some of the most poignant:
• The U.S. President can appoint 5 of the 18 board members of Fannie and Freddie
Many of the most influential politicians involved with Fannie and Freddie, such as Massachusetts Congressman Barney Frank, have attempted to argue that “nobody should be under any illusions that there is any guarantee, implicit, explicit, whatever-plicit” (10) on the governments behalf; the implication of such a backing being that the federal government would come to the rescue of Fannie and Freddie, along with their creditors, in the event of a financial crisis (11). But despite the claims of Congressman Frank and others, the only way financial investors are able to reason how Fannie and Freddie could have such special protections, while also being charged with a political mission, is in believing that the GSE’s debt is government-backed. Despite the sentiment of Congressman Frank, both Washington and Wall Street have an incentive for an “implicit guarantee” to be perceived: Fannie and Freddie’s debt is treated more favorably by the markets as a result (12).
The political and profit-based incentive arising from this implied guarantee has allowed Fannie and Freddie to never meet market discipline or serious federal regulation. On the regulation side, Fannie Mae and Freddie Mac are “among the most politically powerful entities in Washington” supplying not only their own lobbyists to prevent regulation, but also those supported by the industries that benefit from homeownership (builders, bankers, underwriters) (13), and subsequently the politicians that benefit through contributions from those industries. Former Fed Chair Alan Greenspan noted the dangers that arise from GSE’s not facing market discipline as he testified to the Senate Banking Committee in 2004:
"As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties’ strength. However, many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSE’s special relationship to the government." (14)
The lack of either market or regulatory transparency of Fannie and Freddie allowed for fraud, the overstatement of earnings, and an emphasis on profits (both financial and political) over their initial statutory mission (15).
The most devastating example of the GSE’s excess, one that both laid the foundation for our current financial crisis while best exemplifying the lack of taxpayer protection in Fannie and Freddie began in 1998. As Fannie Mae shareholders put pressure on Fannie Mae Chairman Franklin Raines to “maintain its phenomenal growth in profits” (16) the Clinton administration correspondingly applied pressure for Fannie and Freddie to make it easier for “subprime borrowers” (borrowers whose incomes, credit rating, or savings would typically preclude them from qualifying for a loan) to get loans by having Fannie and Freddie buy and securitize sub-prime mortgages from the primary market. Congressman Barney Frank, along with the Clinton administration and others “used the regulations of the Community Reinvestment Act [an act passed during the Carter administration that encouraged lenders to lend to people in low-income communities] to threaten lenders into making these loans.” (17)
Given the powerful status in both Washington and Wall Street of Fannie and Freddie, investors obliged, assuming the increased risk was government-backed, and proceeded to reap the profits of subprime investment. And Washington, eager to reap the political benefits of expanding homeownership to “minority and low-income home owners who tend to have worse credit ratings than non-Hispanic whites,” (18) was equally happy to pursue this taxpayer-backed risk. Though many, including American Enterprise Institute fellow Peter Wallison, were able to predict what would occur nearly a decade later: “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the savings and loan industry.” (19)
The rest, as the cliché says, is history. The “reckless expansion” (20) of Fannie and Freddie helped form the housing bubble, which, thanks to the government guarantee of the GSE’s, led investors into the subprime market, which in turn laid the foundation for the current U.S. economic meltdown. Former Treasury Secretary Larry Summers best articulates the root cause of the crisis; not a crisis of colliding circumstances, but an inevitable crisis resulting from the inherent contradiction of interest between the shareholder and the taxpayer:
"What went wrong? The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation. When there were social failures the companies always blamed their need to perform for the shareholders. When there were business failures it was always the result of their social obligations. Government budget discipline was not appropriate because it always emphasized that they were “private companies.” But market discipline was nearly non-existent given the general perception – now validated - that their debt was government backed. Little wonder with gains privatized and losses socialized that the enterprises have gambled their way into financial catastrophe." (21)
In light of the GSE’s role in the current economic crisis, it would be logical to assume that the U.S. government has proposed serious reforms to Fannie and Freddie to address their inherent failings, or at least their role in the housing crisis. But such a call for reform would require federal officials who benefitted from Fannie Mae and Freddie Mac, both politically and financially, to recognize the inherent contradiction of a private company with a public mission, to say nothing of taking personal responsibility for the now-apparent results. In either case, history demonstrates that responsibility is not a part of Fannie and Freddie’s story.
Thus far, the only proposed “reform” of Fannie and Freddie has come from former Treasury Secretary Henry Paulson. Paulson “said the best option would be for the mortgage giants to be run like public utilities - privately owned but governed by a commission that would establish a targeted rate of profit.” (22) The Obama administration has yet to weigh in on this proposal, or offer one of their own, but since the nationalization of Fannie and Freddie in the fall of 2008, the two GSE’s have become “increasingly an arm of the federal government.” (23)
Paulson’s proposal however does little to address the fatal flaw of Fannie and Freddie’s design, the contradictory interests and governing needs of shareholders and taxpayers. In fact, it does little to preclude the political influence that inhibited previous attempts at regulating the GSE’s, and does even less to prevent the two entities from being used to further political aims as they were in the late 1990’s. The extent of Fannie and Freddie’s political influence makes any attempt at regulation while remaining as GSE’s a futile one. In fact, as Alan Greespan noted in previously cited testimony, “if the regulation of the GSE’s is strengthened, the market may view them even more as extensions of the government and view their debt as government debt.” (24) Further, Paulson’s proposal does nothing to address the danger inherent to two, taxpayer backed entities, monopolizing the overwhelming majority of risk in one market. The concentration of wealth in the form of monopolies is condemned in the private sector, and it should be in the public as well.
These principles, the spreading of risk to several, smaller companies, the elimination of all government backing or privilege, and the dissolving of political ties between the GSE’s and the U.S. government to ensure genuine regulation can be best achieved through an actual privatization effort. While the need of market liquidity for middle-class homebuyers inspired the creation of the GSE’s, such a need no longer exists enough to merit the risk Fannie and Freddie place on the taxpayer. As made clear in the evolution of the current economic crisis, Fannie and Freddie only add liquidity to the housing market during economic booms. They can in fact spread negatively in downturns; too much of a mixed bag to warrant their perpetual taxpayer risk. Of course, privatization should not be pursued hastily. A privatization plan that would disrupt the housing market in a way similar to the existence of Fannie and Freddie is not worth the transition, nor is one that would deliver worse benefits to homebuyers and owners.
Thomas Stanton developed a privatization plan for the American Enterprise Institute that addressed many of these concerns by shrinking Fannie and Freddie’s the amount of MBS’s in their portfolio’s as they transition into private companies, while having them continue to securitize mortgages as they transition into the private sector. Such efforts are worthy of consideration as long as they are founded on the principles of spreading risk, no monopolies, the elimination of government privileges and political connections. Addressing these principles will provide sound protection for taxpayers that is currently lacking in Fannie and Freddie, making them both far too big of a danger to save.
1: Zibel, Alan “Moffett resigning as Freddie Mac CEO” © 2009 The Associated Press, published March 2nd, 2009
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