How About Leaving Fannie Mae & Freddie Mac Alone?

People in Congress and the Trump administration keep repeating — lately with added emphasis — that something must be done about Fannie Mae and Freddie Mac, the giant mortgage banks that have been wards of the state ever since their failure in the 2008 financial crisis.

Actually, given the options under consideration, the best approach might be to do nothing at all.

The travails of Fannie and Freddie illustrate eloquently how a public-private partnership can go wrong. For decades, the two operated as privately owned companies, but with a congressional charter to guarantee payments of interest and principal on mortgage loans — guarantees that underpin the traditional 30-year fixed-rate loan, support a global market for U.S. mortgage-backed securities, and make homeownership accessible to millions of Americans.

The crucial role that Fannie and Freddie play in housing finance led investors to think the government would always rescue them in an emergency. This let the two borrow cheaply, operate with very little capital, and deliver impressive profits to shareholders. After the housing bust, investors were proved right: The government stepped in with $187.5 billion in taxpayer funds.

Since then, the government conservatorship has provided a sort of clarity: Taxpayers still stand behind the guarantee, but now collect the profits. It has worked pretty well. Fannie and Freddie kept credit flowing through the recession and recovery, adjusted fees to better reflect risk, and paid almost $300 billion in dividends to the Treasury — money that serves as capital, available to cover losses in the next downturn. Still, the situation isn’t ideal. For one, there’s a rump of private shareholders — mostly hedge funds — that want a share of the profits. More important, the government never intended to stay so deeply involved in the mortgage market for so long.

What to do? So far, the plans being considered aim to resurrect the private guarantee business. The latest congressional version, offered by Senate Banking Committee Chair Mike Crapo, envisions a number of privately owned guarantors competing with a newly privatized Fannie and Freddie. It’s hard to see what purpose this would serve. The government would still be standing behind the guarantees, with the companies acting as gatekeepers. The biggest profits would go to those that took the greatest advantage of the backstop by offering easy terms and putting up as little of their own capital as possible — perverse incentives that even burdensome regulation, such as limits on market share, would struggle to contain. Yet again, private shareholders would get the benefits, with taxpayers standing by to absorb the costs.

The good news is that a divided Congress is unlikely to approve Crapo’s plan. The bad news is that, absent congressional action, the Trump administration might opt for something even worse: “recap and release,” as it’s called, in effect returning Fannie and Freddie to their pre-crisis state.

This approach would most likely mean diverting money from taxpayers to rebuild the enterprises’ own capital — a vast windfall for the private shareholders, who naturally support the plan. It’s hard to see, though, how this would benefit anyone else. More stringent capital regulation might help, but the enterprises would still tend to overindulge in risk and underpay for the backstop that only the government can provide.

If legislators were serious about mending the housing-finance market, they’d be looking at other ideas. For instance, they could merge Fannie and Freddie into a single government corporation that would be required to transfer most credit risk to a broad range of private investors — with government covering only the catastrophic risk that private capital can’t credibly bear, in return for a fee. This would be the most straightforward solution. It would dispel uncertainty, protect taxpayers, and make the government’s role explicit. It would also help align the price of guarantees with the market cost of capital, opening the way for real competition from more completely private lending channels and even for experiments with alternatives to the 30-year fixed-rate mortgage.

Attempted all at once, though, this approach would meet strong political resistance. The best course for now is therefore to let Fannie and Freddie continue on their current path — which happens to be trending in the right direction. They’re already issuing a new kind of security that transfers the risk of losses to investors. Eventually, this could be enough to protect taxpayers in all but the most extreme cases. The government’s footprint would be smaller, and it wouldn’t be backstopping private institutions or enabling them to take on risks that they didn’t intend to bear.

That would be progress, and it’s feasible. If the right kind of reform can’t be done now, Congress and the White House would be wise to settle for “do no harm.”

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