What shape should Fannie Mae and Freddie Mac take after the current crisis is past? That decision will be left up to the next president, but even as the candidates, policy makers and financial players are trying to sort out the short term impact of the Treasury Department’s bailout of the two mortgage giants, a contentious debate has already begun about how they their role should be redefined for the long term. Nationalize them? Privatize them? Or simply shrink them and regulate them more heavily?
Larry Summers, who served as Treasury Secretary under President Bill Clinton, has long worried about the risks the two posed due to their large size, extensive investments in mortgage-backed securities and minimal regulation; in late July, he wrote a widely noted article in the Financial Times in which he argued that if the government was forced to take them over, it should ultimately break them up. It should “divide their functions into government and private components, the latter of which would be sold off in multiple pieces,” he wrote. Summers was speaking in Washington today at a conference on supply side tax cuts at the Center for American Progress, a liberal think tank, and afterwards, I asked him to elaborate on his view of how Fannie and Freddie should be restructured.
Summers argued that “the best overall form they should take remains unclear” but several principles must guide the policy decisions ahead. First, Summers believes that Fannie and Freddie’s longstanding mission of making home ownership affordable for low income buyers should be preserved. “There is a clear need for a public actor to help ensure housing affordability for credit-worthy homeowners in all income brackets,” he said. Summers also added that “there is a clear need to backstop the (mortgage) market in times of cyclical financial distress.” In other words, when investment banks, hedge funds and other investors stop buying mortgage-backed securities because the outlook is bad -– as they have for much of the last year – Fannie and Freddie have an important national function to play in keeping the market liquid and functioning.
Both those views stand in sharp contrast to many conservatives, who would simply shrink Fannie and Freddie and sell the downsized firms to private buyers. They see little need for the programs geared to improving housing affordability, and argue the market for mortgage-backed securities should function like any other: when private investors feel confident in the market again and believe it is in their financial interests to buy or sell the securities, they will.
Summers was equally clear that whatever public entities eventually succeed Fannie and Freddie, they should no longer be able to invest in mortgage-backed securities for their own portfolios. “There is no need for the public sector to backstop an arbitrage activity with taxpayer-supported borrowing,” he said. The growth in such investments – which essentially allowed Fannie and Freddie to operate giant hedge funds with government-subsidized funding – was hugely profitable for shareholders and management in recent years, but was ultimately a big reason for their downfall.