Time to Let Fannie and Freddie Wither?

In good times, they were superfluous. Now they're only as good as their U.S. guarantee

Are Fannie Mae (FNM) and Freddie Mac (FRE) really too big to fail? That's certainly a widely held assumption across much of the political spectrum. Republican Presidential candidate John McCain voiced the conventional wisdom on July 10 when he said, "They must not fail." Democrat Charles Schumer, the New York senator, agreed, saying: "Markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac."

On July 11, shares in the two companies briefly dropped about 50%, but recovered late in the session. Investors are concerned that if house prices continue to fall and foreclosures rise, losses on Fannie and Freddie's portfolios of mortgage-backed securities will force them to turn to the government for help. The condition for a government rescue, if one were needed, might force shareholders to lose their entire investments.

But while it's clear that Fannie and Freddie can't be allowed to go under abruptly, a good case could be made that the two mortgage financing giants headquartered in Washington's Beltway are part of the problem in housing (BusinessWeek, 6/26/08) rather than part of the solution. If that's so, then this might be an opportune moment to let them begin slowly to wither away.

Contributors to the Housing Bubble?

Some people are already making that case. Peter Schiff, head of Euro Pacific Capital and a bear on the U.S. economy, has been a longtime critic of Fannie and Freddie. He blames them for helping inflate the housing bubble. Says Schiff: "It was a self-perpetuating spiral. We would buy things and send these dollars abroad. And because yields on Treasuries were so low and foreigners had so many dollars, the vehicle of choice was Freddie and Fannie bonds."

The flow of foreign money into U.S. mortgage-backed securities—from places like China, Japan, and the OPEC nations—stimulated a boom in home purchases. The ready availability of money also drove home prices higher, making them less affordable and ultimately leading to the bust that we're living through now. The aftermath: a wave of foreclosures and a big increase in U.S. external indebtedness.

It's true that the U.S. would have had a growing foreign debt even without Fannie and Freddie. But they were key parts in a well-oiled machine that encouraged Americans to borrow more and foreigners to sink their savings into U.S. investments instead of spending the money at home (or buying imports from the U.S.).

Execs and Shareholders Benefited

Fannie and Freddie have enjoyed strong political support for decades because of the perception that they helped millions of people achieve the American dream of homeownership. Lately, though, with prices falling, homeownership hasn't looked like such a great bargain. What's more, close studies of the companies by the Federal Reserve indicate that they have lowered mortgage interest rates by just a fraction of a percentage point. The Fed also found that the companies' executives and shareholders have reaped most of the benefits of the market's perception that their obligations would be supported by the federal government in a crisis.

No question, Fannie and Freddie appear indispensable today because they're pretty much the only standing players in the mortgage-buying business. Private mortgage securitizations have ground to a halt, and few banks are willing to make mortgage loans that they keep on their books. The result is that if you want a mortgage these days, you're counting on Fannie and Freddie. Except for a small number of jumbo mortgages and loans guaranteed by the Federal Housing Administration, the vast majority of U.S. mortgages in recent months have been bought or guaranteed by one of the two companies.

But that only goes to show that Fannie and Freddie have used their implicit government guarantee to undercut rivals and push them out of the lending business. If they faded away, it's likely that over time new lending channels would open or reopen, says Schiff. "We need to go back to traditional lending," he says.

Making Lending Attractive Again

That's not to say that Fannie and Freddie could safely disappear overnight. Even William Poole, the former president of the Federal Reserve Bank of St. Louis and a leading critic, said that it's essential to make sure that Fannie and Freddie can continue to buy mortgages. Over the long term, though, their function could become less important and their portfolios could shrink if banks and nonbank mortgage lenders get back into holding loans on their own books, or private-label securitizers expand. The key to the transition would be a slight rise in interest rates, big enough to make lending attractive again for Fannie and Freddie's competitors.

The trouble with the guarantees that Fannie and Freddie make on mortgages is that in good times, they're superfluous—it's easy to get a mortgage even without that guarantee—while in the bad times, such as now, it becomes clear that the guarantees are only as good as the U.S. government's credit.

If that's the case, it might make more sense to nationalize Fannie and Freddie, or have the government take over their function of keeping mortgage money flowing during financial crises. Says Joshua Rosner, an analyst at Graham Fisher & Co., about Fannie and Freddie: "My personal view is you don't really need them."

Fannie Mae and Freddie Mac showered huge paychecks and bonuses on their top executives when times were good. Now that money is tight, Administration officials are quietly discussing how to stage a possible bailout if matters get worse. It's a classic example of privatized gains and socialized losses. That's why this might be the right time to let the two wither away.

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