May 20 (Bloomberg) -- Once upon a time, there lived a King who granted each subject enough money to make his home his castle.

Everyone was content. The castles created vast riches throughout the land.

Alas, the King had large armies to support, and the royal coffers had run dry. So he levied a tax on each household. And there was much misery throughout the land. The people rose up in protest. The King and his ministers knew not what to do.

One day a fairy godmother named Fannie appeared.

``I have come to grant you one wish,'' Fannie Godmother said.

``One wish! Let us keep buying castles,'' the people said.

``I will grant you your wish,'' Fannie Godmother said. ``You will have money to buy new castles.''

And everyone lived happily ever after.

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Sound like a fairy tale? It isn't. It's basically what happened last week, with Fannie Mae, the largest mortgage lender, doing an about-face, easing loan standards after tightening them in December following an increase in defaults and dislocations in the mortgage, housing and securitized loan market.

Poor Public Policy

Specifically, Fannie announced it will now accept mortgages with a loan-to-value (LTV) ratio of up to 97 percent on a primary, single-family residence, even in areas where prices are declining.

``I'm not even sure this makes sense as public policy,'' says Michael Carliner, an independent housing economist in Potomac, Maryland. ``Fannie should be making loans, but the underwriting standards shouldn't be lowered to that extent.''

Just think about it: With home prices in a handful of hard- hit areas of California and Florida down 10-15 percent last year, according to data from the Office of Federal Housing Enterprise Oversight, or Ofheo, Fannie's regulator; and with widespread expectations that prices will continue to fall to attract buyers, Fannie Mae is loosening down-payment requirements when a house in these areas could be worth less than its loan value in a matter of months?

Political Pressure

The only reason to ease standards is public pressure: from Congress, from Fannie's friends in the housing industry and from homeowners' advocacy groups.

It would be one thing if Fannie were a private company and decided the potential return justified the additional risk. In that case, it would be an issue for the shareholders.

Fannie Mae and smaller sibling Freddie Mac operate in this murky zone: part public, part private. As a quasi-government organization created by federal charter to provide liquidity for the mortgage market, Fannie and Freddie benefit from an implicit government guarantee (low borrowing rates) and tax-exempt status. Yet those advantages accrue only partially to homeowners. The rest goes to their bottom lines.

``Only an entity that gets to play with Other Peoples' Money would dare to do something so foolish with its capital as Fannie is doing,'' writes an e-mail correspondent. ``In the face of a huge re-adjustment downward in housing prices, the company is lowering lending standards and turning on the credit hose.''

Public or Private?

Public risk, private profits. Fannie was quick to make it seem as if its shift was justified.

``We are able to adopt this new, national down-payment requirement, even in markets where home prices are declining, because our new automated underwriting risk assessment model DU Version 7.0 will limit risk layering and assess each loan more precisely,'' the company said in a statement.

I wouldn't know model DU Version 7.0 from model DU Version 6.0. It's still a model that uses information about the borrower and the property to determine the viability of a loan. Falling home prices, which can eliminate that 3 percent equity stake in a jiffy, aren't one of the inputs. (Fannie has other models that forecast house prices.)

Didn't we learn anything over the past two years? We're still mopping up from the effects of lax loan standards, with delinquencies and foreclosures rising and profits at financial institutions falling.

Equalizing Risk?

Because Fannie and Freddie require borrowers who put less than 20 percent down on a home purchase to buy mortgage insurance, Fannie's relaxation of LTV standards may be a moot point. Mortgage insurers are reeling from losses and may not be willing or able to write insurance for loans with a 97 percent LTV in areas where home prices are declining. That could push Fannie to self-insure, raising the fee it charges for purchasing or guaranteeing mortgages, according to some housing analysts.

In a speech last week, Ofheo director James Lockhart applauded Fannie's move to ``equalize'' (the company's words) LTV lending standards. In the same breath, he said Fannie and Freddie posed ``significant risks to taxpayers'' and the financial system.

That makes no sense, unless this is a fairy tale. Equalizing the down-payment requirement won't equalize the risk of losses.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: May 20, 2008 00:03 EDT