Rethinking Fannie and Freddie

When the history books are written about America's early 21st Century financial system breakdown, what will they make of Fannie Mae and Freddie Mac? These two government-sponsored enterprises (GSEs) that own or guarantee 76 percent of all mortgage originations were at the center of the credit market collapse. Bailing them out has cost the U.S. taxpayer $145 billion and counting.

Yet while Wall Street executives, credit rating agency managers, and Bush-era regulators have been hauled into the public square, comparatively little time has been devoted to repairing these two entities, which have been in conservatorship for 20 months. With little public discussion, Uncle Sam has basically nationalized their $5.5 trillion in home-loan assets. The Obama Administration has pledged to cover unlimited losses at Fannie and Freddie through 2012, a commitment that goes beyond a prior credit line of $400 billion (which itself had been doubled). In early May, Fannie posted a $13.1 billion loss while Freddie fessed up to losing $6.7 billion. The pair now tote $340 billion in nonperforming assets.

More disturbing than the sheer costs involved is the lack of discussion of how best to fix, privatize, or even phase out these giants. Congress is busily trying to overhaul other sectors of the U.S. financial system, namely large commercial banks, the securitization industry, and derivatives trading. Yet it's hard to see how any fix would be comprehensive without reform of Fannie and Freddie, two institutions so central to U.S. home finance. It's "like declaring war on terror and ignoring Al-Qaeda," said Senator John McCain. On May 11 the Arizona Republican tried unsuccessfully to phase out the companies' taxpayer lifeline as part of the regulation reform bill. Instead, the Senate settled for exhorting the Treasury Dept. to study how to wean Fannie and Freddie off the dole.

Too bad, because there is an illuminating policy debate to be had about these two government-hatched siblings. Theirs is a tale of industrial policy run amok—enabled by creative accounting, circular financing, a lack of transparency, and Washington's penchant for marrying politics with sociology. Fannie and Freddie were originally created to buy mortgages from local banks so the banks could lend again. Successive administrations used them to achieve various goals, including expanding low-income housing and minority homeownership. At the same time, the companies grew rapidly and became highly profitable. Their implicit government guarantee allowed them to tap the credit markets whenever they wanted, and at favorable interest rates.

In the early 2000s, when rivals stole market share by packaging the subprime mortgages that Fannie and Freddie at first eschewed, the companies switched course and bought hundreds of billions' worth of the risky loans. That, and ill-timed accounting scandals, were their undoing. "Fannie and Freddie are the poster children of the moral hazards of government guarantees—even implicit ones," says Craig Pirrong, professor of risk management at the University of Houston.

Now the Treasury Dept. is again using Fannie and Freddie as tools of social policy by requiring them to spearhead loan-modification programs for distressed homeowners. They are single-handedly keeping the nation's mortgage machine going as the only ones buying and securitizing home loans from originating lenders. Without Fannie and Freddie, it would be nearly impossible to buy or sell a home today. Meanwhile, they must pay billions in dividends to Treasury (which, to complete the loop, is funding them) as part of their conservatorship.

Not that anything approaching the true carrying cost of all that red ink is appearing on the government's balance sheet. Only the draw-down of the now-unlimited taxpayer backstop hits the government's books. This is a great deal for Washington, which gets to control the $5.5 trillion mortgage-finance market for a mere $20 billion or so a quarter. The real-time, mark-to-market losses are kept out of Administration talking points on the cost of the bailout. As recently as Apr. 23,Treasury Secretary Timothy Geithner told Congress that rescue programs will tally only about $87 billion, including Fannie, Freddie, and the Troubled Asset Relief Program.

The Congressional Budget Office, which isn't authorized by Congress to undertake a full accounting of Fannie's and Freddie's finances, figures that keeping the pair afloat will cost taxpayers $389 billion between 2009 and 2019, even more than American International Group's (AIG) bill. "This is the pushing-under-the-table of those losses," says Robert Pozen, the chairman of Boston-based fund shop MFS Investment Management who led a committee to improve financial reporting for the Securities & Exchange Commission in 2007.

Geithner has so far told Congress that Fannie and Freddie "will not exist in the same form as they did in the past." There is, however, no timetable for reform. In the interim, the housing-finance giants remain in limbo: They can't continue as they are, and the fragile economy can't function without them. "Washington has essentially nationalized mortgage credit," laments Doug Noland, senior portfolio manager of the Federated Prudent Bear Fund and a longtime critic of the GSEs. "It's difficult to see how the private sector can now go alone without government guarantees."

There is a reason why Fannie and Freddie have only grown in scope. No matter which political party has been in control: They exist outside the checks and balances taught in seventh-grade civics class. "They are now being used as a conduit for the executive branch to spend money for policy purposes without having to get a vote and without transparency," says Phillip Swagel, a Treasury economist under President George W. Bush who now lectures on financial crises at Georgetown University's McDonough School of Business.

Taking on Fannie and Freddie involves taking on the very notion of home ownership for everyone. However flawed an aspiration that may have proven to be, it's still one that remains sacrosanct in Washington.

The bottom line: As Congress fixes flaws in the financial system, no serious fix for Fannie Mae and Freddie Mac is under serious consideration

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