The Future of Fannie and Freddie

Colossal and enfeebled, the two mortgage giants are now part of the problem. The case for an extreme makeover
For now, Paulson wants to reassure the markets, not discuss changing the two agencies Brooks Kraft/Corbis

Fannie Mae (FNM) and Freddie Mac (FRE) have never seemed more indispensable than in the current credit crisis. They are the last nongovernmental players standing in the business of buying mortgages. On July 15, Treasury Secretary Henry M. Paulson Jr. asked Congress for unlimited authority to lend to them to reassure markets of their creditworthiness. He compared the requested credit line to a bazooka he hopes will never have to be used.

Oddly, though, the very fact that policymakers are bending over backwards to protect Fannie Mae and Freddie Mac makes it all the more important to talk about whether they should, in the long run, live or die. When this crisis is over, should these quasi-public, shareholder-owned companies be nationalized? Privatized? Closed down entirely? Or left essentially intact, except perhaps with smaller portfolios and tighter regulation? The emerging debate will sweep up a wide range of issues, from Fannie and Freddie's implication in the housing bubble to national competitiveness.

It may seem premature to plan for a restructuring in the middle of an emergency, but short-term fixes could have harmful consequences if they wind up being permanent. Peter D. Schiff, the head of brokerage Euro Pacific Capital, says Paulson's "bazooka," by propping up Fannie and Freddie, would allow them to buy "more mortgages on overvalued homes," with U.S. taxpayers and foreign dollar holders ultimately picking up the tab.

Questions about the proper role of Fannie Mae and Freddie Mac have come to a head because the companies lost the confidence of investors at the moment they were most needed—when other mortgage buyers had gone on extended holiday. The Treasury Dept. and Federal Reserve made emergency statements of support on Sunday, July 13, for fear that without their explicit backing the firms might not be able to keep raising money. Worries that a potential government takeover or restructuring would wipe out shareholders have driven the two companies' stock prices down nearly 90% over the past year. The market consensus now is that the two companies don't have the resources to survive a severe market downturn without government backing.

The fate of Fannie and Freddie is hugely important because the two have grown to dominate the U.S. mortgage market. Fannie dates back to the Depression year of 1938; Freddie to 1970. Although they don't originate loans, they own or insure about 40% of the $11 trillion in residential mortgages in the U.S., according to Inside Mortgage Finance, a trade publication.

From an economic perspective, the chief complaint is that Fannie and Freddie exacerbate swings in the housing market instead of dampening them. In the boom that began around 2000, Fannie and Freddie formed a critical link in the transfer of savings from countries like China and Japan to home buyers in America. They packaged their debt conveniently to resemble U.S. Treasuries, and although the debt didn't carry the explicit backing of the government, many foreign buyers assumed—correctly, it turns out—that the government wouldn't let Fannie and Freddie default. China alone owned $387 billion of securities of Fannie Mae, Freddie Mac, and other government-sponsored enterprises as of mid-2007, or 27% of the total owned by all foreign countries.

Homes But No Jobs

In short, Fannie and Freddie were not just passive bystanders in global capital flows. Says Brad W. Setser, a fellow at the Council on Foreign Relations: "The agencies became a mechanism that allowed the U.S. to transform a pool of mortgages, which wouldn't be a classic central bank asset, into a set of assets that foreign central banks found attractive." It's possible, says Setser, that if not for the two companies, more foreign money might have gone into corporate bonds. That would have meant more investment by U.S. companies in capital equipment—and less in housing, which does little to boost U.S. competitiveness. As it is, too many Americans have beautiful homes but no jobs.

When the bust came, Fannie Mae and Freddie Mac kept packaging mortgages for sale even after others had gotten out of the business. But they were also losing money. And because they were thinly capitalized, it didn't take big losses to make investors worry about two stocks long viewed as bulletproof.

What made Fannie Mae and Freddie Mac vulnerable is that they aren't just intermediaries between lenders and investors. They themselves have amassed about $1.5 trillion worth of mortgages and mortgage-backed securities. This mountain of assets is highly profitable for their shareholders in good times because it's financed with money borrowed at Fannie's and Freddie's artificially low cost of debt, but now it's the cause of huge write-offs. And according to studies by the Fed and others, these purchases for their own portfolios do little to make mortgages cheaper or more available.

There's a good argument to be made that once the crisis is over, Fannie and Freddie should be forced to stop buying securities for their own portfolios and allow their assets to shrink by attrition. They would continue to perform their other, well-accepted role, namely buying mortgages, bundling them into securities, placing a guarantee on them (for which they charge a fee), and selling them to other investors.

"Turning over Every Stone"

No screaming rush on this, to be sure. In current conditions, it would be disastrous for Fannie and Freddie to abruptly cut their purchases to free up capital. They have been buying mortgages for their own portfolios for so long that the housing market has become addicted to their purchases—even more so now that other channels of credit have dried up. In the long run, though, the housing finance market would be healthier if the nation's mortgages and mortgage-backed securities weren't so highly concentrated on the books of two undercapitalized companies.

Assuming Fan's and Fred's new regulator does shrink the portfolio drastically—which might take three to five years, estimates Peter J. Wallison, a fellow at the American Enterprise Institute—the choice then will be how to remove the companies from the financial and legal gray area of their quasi-public, quasi-private status. That unusual position allows members of Congress to exert authority over the companies to achieve legislative goals, and it has benefited shareholders. But it's dangerous to taxpayers. Senator Richard C. Shelby (R-Ala.), a critic of Fannie and Freddie, told Treasury's Paulson on July 15 that he's skeptical of giving an unlimited credit line to the companies. Said Shelby: "A blank check? I'm not so sure. We'll have to talk."

One option is to nationalize the companies, or rather renationalize them, since both began as federal agencies. Nationalization would bring the companies' social goals to the fore.

Conservatives would prefer to go the other direction and privatize the companies fully, stripping away the government charters that commit them to helping achieve national housing goals. "The idea has become part of acceptable conversation," says Wallison.

This debate is just beginning. Paulson and Bernanke say that for now they support keeping Fannie and Freddie in their current forms. Treasury's main reform initiative is to import a European invention called the covered bond, which is a safer—though lower-yielding—alternative to Fannie's and Freddie's residential mortgage-backed securities. Says one Treasury official: "We are turning over every stone looking for incremental ways to help the housing market."

The severe housing slump should be Fannie Mae's and Freddie Mac's finest hour. Instead, they find themselves under withering scrutiny as part of the problem, not the solution.

    Before it's here, it's on the Bloomberg Terminal.