What If Fannie And Freddie Fly The Coop?

The mortgage giants could opt for growth instead of government protection

Fannie Mae and Freddie Mac have built hugely profitable and rapidly growing businesses largely on special privileges Congress gave them to promote homeownership. But the latest debate in Washington could force the scandal-plagued housing giants to decide which they value more: government privileges or the soaring growth.

At stake is $1.56 trillion in mortgage investments that Fannie and Freddie -- known as "government-sponsored enterprises," or GSEs -- own. Federal Reserve Board Chairman Alan Greenspan and the Bush Administration want to shrink those portfolios to as little as $200 billion. Greenspan argues that tough limits would reduce the financial risk of the GSEs' undiversified holdings. GSE supporters note that the move would also shrink Fannie and Freddie -- a long-held goal of many conservatives.

Charged by Congress to help make housing affordable, Fannie and Freddie each operate two lines of business. Their credit-guaranty operations buy mortgages from lenders, package the loans into securities, stamp the securities with a guarantee against homeowner defaults, and sell the securities to investors. That business is low-risk and immensely profitable: The Fed figures securitization earns 25% returns on the GSEs' capital.

But it doesn't offer the same growth potential as the mortgage portfolio. Thanks to their quasi-governmental status, the GSEs can borrow more cheaply than competitors. Regulators say Fannie and Freddie also skim off the safest loans to hold for themselves. Since 1992 -- while Fannie and Freddie were becoming two of Wall Street's favorite growth stocks -- their portfolios grew 722%.

That rapid expansion lies at the heart of the GSEs' accounting scandals. Owning mortgages can be risky, because falling interest rates encourage homeowners to refinance and pay off loans early. To hedge their one-way bet on rates, Fannie and Freddie are big players in derivatives. But they didn't account properly for those hedges: Fannie must mark down its earnings by an estimated $9 billion, and Freddie lowballed profits by $5 billion. Those scandals have spurred Congress to create a new GSE regulator. But critics are using the opportunity to press for limits on Fannie's and Freddie's investments.


The GSEs' still-formidable lobbying machines are fighting back. At Senate Banking Committee hearings on Apr. 19 and 20, homebuilders, real estate agents, and small lenders insisted that the GSEs' portfolios keep interest rates down. Freddie CEO Richard F. Syron warned that limits could cut funds for low-income home buyers. And Interim Fannie CEO Daniel H. Mudd said 30-year fixed-rate mortgages could be threatened, because other loan buyers would rather hold adjustable-rate mortgages (ARMs).

This time, though, the GSEs' apple-pie-and-homeowners arguments may not prevail. Low-income buyers aren't at risk, says Patrick Lawler, chief economist for the Office of Federal Housing Enterprise Oversight, because "most affordable housing programs are quite profitable." And Greenspan told the banking panel that "there is no evidence which suggests a deficiency" of buyers for 30-year loans.

If Congress does move to put them under strict limits, would Fannie and Freddie consider giving up the government breaks that let them borrow so cheaply? Long before the accounting scandals, a former Clinton Administration official says, Fannie execs mused about dropping the charter so they could expand outside the mortgage market. Now pressure is growing. "If they want to avoid being shrunk, they have to think seriously about coming up with their own privatization plans," argues Peter J. Wallison, resident fellow at the American Enterprise Institute.

Fannie and Freddie insist such talk is premature. But the fact that privatization is in the air shows just how far the mighty housing financiers have fallen.

By Mike McNamee in Washington

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