An American housing finance dilemma: What to do with Fannie Mae and Freddie Mac?


Article Highlights

  • What should be done with Fannie Mae and Freddie Mac is the biggest question of the $10 trillion, post-crisis American housing finance sector.

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  • Virtually everyone agrees that the United States should not return to the flawed, indeed disastrous GSE model.

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  • Congress could enact a medium-term program to move toward a more private, less government-dominated mortgage sector.

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What should be done with Fannie Mae and Freddie Mac is the biggest question of the $10 trillion, post-crisis American housing finance sector. Essentially no progress has been made on this question.

Fannie Mae and Freddie Mac were and are unique features of American housing finance compared to other countries. According to their own pre-crisis publicity, Fannie and Freddie made U.S. mortgage lending “the envy of the world.” In those days, Fannie and Freddie were accustomed to being the stars and darlings of both Washington and Wall Street – or more precisely, being a darling of Washington made them a star of Wall Street. Fannie in particular was also a greatly feared bully boy in both Washington and Wall Street, whom most politicians and bankers were afraid to cross or offend.

Perhaps drunk with the sight of power and hubris, the free use of the U.S. Treasury’s credit, and nearly unlimited command of other people’s money, domestic and international, Fannie and Freddie became major perpetrators of the housing bubble, running up the leverage of the housing finance sector, inflating house prices, escalating systemic risk, and making boodles of bad loans and investments.

As in a Greek tragedy, their hubris led to humiliation. They went utterly broke, greatly embarrassing their political cheerleaders and allies, including Senator Dodd and Congressman Frank (the chairmen of the respective Congressional banking committees), but their taste for using other people’s money did not abate. They lost all the profits they had made for the previous 35 years plus another $150 billion. These enormous losses were foisted on the innocent public, while the government made sure that their creditors, domestic and foreign, were paid every penny on time. Large additional losses to the public are the deadweight bureaucratic costs of the Dodd-Frank Act, sponsored by the aforementioned former political cheerleaders.

Now the housing crisis that Fannie and Freddie made so much worse has finally ended, and the housing cycle is turning back up, as cycles inevitably do. In the mean time, the U.S. housing finance sector has become a largely nationalized and socialized “government housing complex.” As the central part of that complex, Fannie and Freddie, now owned by, run by, and simply part of the government, have attained even greater monopoly power and even more dominant market share than they had before the crisis – an ironic outcome! They have returned to reporting large profits, though they are still completely a ward of the U.S. Treasury.

Fannie and Freddie’s current large profits are completely dependent on and buttressed by:

(a) Being guaranteed by the U.S. Treasury, that is, by the ordinary Americans who pay taxes

(b) Being able to run with zero capital and infinite leverage

(c) Being granted generous and indefensible regulatory loopholes by Dodd-Frank’s unfettered bureaucracy, the Consumer Financial Protection Bureau[CFPB]. The CFPB is imposing onerous and expensive “ability to pay” regulation on all private housing finance actors, but gives Fannie and Freddie a free pass, thus reinforcing the flow of business into the government.

(d) Having the Federal Reserve buy huge amounts of Fannie and Freddie’s mortgage-backed securities--$1 trillion and still buying-- but of course no private ones, at yields and spreads only a central bank could love. The Fed’s mortgage buying campaign subsidizes and promotes the monopoly powers of Fannie
and Freddie.

Having arrived where we are now, what should happen next?

Virtually everybody agrees that the United States should not return to the flawed, indeed disastrous, old “GSE” [government-sponsored enterprise] model of Fannie and Freddie before the crisis, with its warped incentives, runaway leverage, and combination of socialized risk, private profit and immense political clout. Nobody I know of is proposing this.

But there the consensus ends and the sharp conceptual and ideological divisions begin. Ideally, in my view, Fannie and Freddie’s current status, which no one wants, should be brought to an end with a five-year transition. What they do which is actually a mortgage business should be truly privatized (not a fake GSE “privatization” as was done with Fannie in 1968). What they do which is actually a government subsidy program should become explicitly a government subsidy program, and be merged into the operations of the Department of Housing/Federal Housing Administration [FHA]/Ginnie Mae. Fannie and Freddie would thus cease to exist as GSEs. The U.S. mortgage finance sector should move to being about 80% private and 20% government, instead of its current heavily nationalized status.

This straightforward program is not likely to be enacted in the current political configuration. Neither are any of the other numerous proposals. But should political stalemate allow Fannie and Freddie to continue their status quo indefinitely? Then as wards of the government, buttressed by the Treasury, the CFPB and the Fed, they will continue for years to build their monopoly power and domination, probably leading us in time into a new out-of-control cycle of excessively leveraged and politicized housing finance.

Perhaps instead we could agree upon and the Congress could enact a medium-term program to move toward a more private, less government-dominated mortgage sector, without making final decisions about Fannie and Freddie’s ultimate fate or role. Such a program could include the following intermediate steps:

1. Reduce the maximum size of loans that Fannie and Freddie can guarantee by 10% a year for seven years, a cumulative reduction of about 50%.

2. Continually reduce Fannie and Freddie’s mortgage and investment portfolios.

3. Change Fannie and Freddie’s charters from perpetual to limited life charters, with expiration and reauthorization required in 2020.

4. Put more private capital in front of the mortgage credit risk of the government. In particular, encourage credit risk retention which is junior to Fannie and Freddie’s guarantees, by high quality mortgage originators, especially by banks and savings banks.

5. Create a formal, legally binding definition of the meaning of Prime Mortgage Loan, which further stipulates that any mortgage loan which is not Prime is Nonprime. The extent of taking on Nonprime credit risk by Fannie and Freddie should be tightly monitored and limited.

6. The definition of Prime should include a counter-cyclical loan-to-value ratio (LTV)/ down payment requirement based on the house price behavior in the relevant market, so that soaring house prices automatically trigger lower LTVs and higher down payments in order to qualify as Prime.

7. Increase the role of local mortgage lenders by authorizing Federal Home Loan Banks to securitize Prime Mortgage Loans which are all credit enhanced by their member banks and savings banks.

8. Enact U.S. covered bond legislation.

9. Entirely close the giant loopholes created by the CFPB for Fannie and Freddie (and for the FHA). If the CFPB has defined valuable consumer protections in its regulations, such protections should apply to all mortgages, without exception.

10. Stop the Federal Reserve from buying any more Fannie and Freddie MBS, so the MBS market can clear, rather than being heavily manipulated by the monetization of mortgages. The housing cycle is definitely rising once again; there is no excuse for the Fed to continue subsidizing the market dominance of Fannie and Freddie.

With such an intermediate program, the U.S. private mortgage market could gain market share, while the share of the nationalized Fannie and Freddie would be reduced. We do not have to know in advance exactly how large this healthy shift would ultimately be. The U.S. can start moving seriously in what virtually everybody agrees is the right direction.

However, the politics of this American housing finance dilemma will not be easily settled. Stay tuned.

Alex J. Pollock, resident fellow at the American Enterprise Institute in Washington, DC

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