The Case for Cutting Fannie and Freddie Loose

Investors didn't appear to buy Henry Paulson's reassurance that regulators would be able to keep Fannie Mae (FNM) and Freddie Mac (FRE) "in their current form as shareholder-owned companies."

After an initial surge in their share prices Monday morning, the stocks of both GSE's closed sharply lower.

Bond investors, who care much less whether Fannie and Freddie will live on as independent businesses, were reassured by Treasury's plan: The cost of default protection on some Fannie and Freddie debt dropped sharply while economists at Wrightson ICAP called Monday's Freddie Mac debt auction "reassuring."

While it's too early to tell if the GSE's will survive their current troubles, it is worth asking whether we even need entities like them in the first place.

First, economists and analysts have in recent years attacked the idea that almost everyone needs to own a home. For example, homeownership ties a worker down, exacerbating regional economic transitions.

Second, a couple of years back some economists looked at how well Fannie and Freddie were doing in their assigned missions of providing opportunities for low- and middle-income households to buy homes and providing liquidity to the mortgage market through the securitization process. Kristopher Gerardi of Boston University, Harvey S. Rosen of Princeton University , and Paul Willen of the Boston Federal Reserve found no evidence that GSE securtization helped lower income households buy more homes or that the GSE's activities have helped improve mortgage market efficiency. Other studies have shown that, at best, the existence of Freddie Mac and Fannie Mae have reduced mortgage rates by about 25 basis points.

So if the social benefits from having Fannie and Freddie in their "current form" don't outweigh the costs, what's to be done?

Before the credit crunch, some commentators -- mostly on the right -- called for the complete privatization of the GSE's. The difference between Paulson's "current form" and complete privatization is the removal of the GSE's chartered status and the end of the implicit (now explicit) backing of the GSE's debt.

"Maybe this experience will lead people to think 'Oh! We don't want to go through this again,'" says Lawrence White, an economist at New York University's Stern School of Business, and writer of research papers with titles like Reforming Fannie and Freddie: Privatization is the Way. But White is not optimistic that even if Fannie and Freddie survive their current troubles, Congress would be open to privatization talks.

Agreeing with White is Peter Wallison of the American Enterprise Institute, author of Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

And if they're unlucky enough to be taken over by the Feds, there isn't a need for new government-chartered institutions to take their place, both White and Wallison say.

This latter scenario will present an interesting dilemma to the next president, especially one from the Democratic Party. What should come first? Something approaching universal homeownership or universal healthcare?

Comments

[bbzz24:]

Zubin,
All that good, but you seem to completely ignore the impact of further reduced lending on current home prices (aka mortgage loan collateral), the impact on the banks levered balancesheets of further write offs, the impact on the broad economy of weak banks and decimated real estate market, and then the appetite of foreign investors to continue to lend money to an ever shrinking economy that becomes more and more levered as asset values evaporate.

Bluntly put if those entities go away, you will be picking tomatoes.

2008 Jul 15 05:18 AM

[tuj:]

Consider the fact that lenders are already charging a premium rate over prime relative to several years ago on a conforming, FX30 product. These are products that are essentially risk-free for an originating bank; Fannie and Freddie guarantee they will buy them. The importance of this cannot be under-estimated. Without this ability to off-load risk, the premium for a FX30 will increase even more over prime, as banks become even more risk-adverse, even on customers that are very well qualified.

The conforming product is something people are under-estimating, and is a historical stable and reliable indicator of repayment. Yes, defaults vary given economic times, and yes, Fannie and Freddie dabbled in a little sub-prime, and some Alt-A (reduced-doc conforming), but their vast bulk of holdings came through CONFORMING products. These are your conventional mortgages, the mortgages that do require income verification, appraisals, etc.

Let these institutions fail, who will off-load the risk for the originators and provide packaging of conforming loans? Who will provide the conforming loan guidelines so that investors buying bonds of conforming loans know that the underlying debt is all of relatively equal quality?

You need these massive institutions to assume the risk, charge a little premium for it, provide packaged, quality bonds for the massive secondary market.

2008 Jul 15 09:27 AM

[Jason Rines...:]

It will become nationalized after the elections and be privatized later. Our current crop of political and economic leadership will be considered in history as the most selfish and mean-spirited since the railroad & banking tycoon era of the 1870's. The depression will hit hard and fast and will dwarf the 1930's where many of the 97% of the U.S. population will go from perceived riches to literal rags. It's going to be harsh and ugly for about four years but our nation is not in the 1930's.

America has far better communications and private equity money to focus on energy, healthcare and education to become extraordinarily efficient in a short amount of time. This is what Treasury and Congress should be doing RIGHT NOW, but there is no investment into innovation, just more socialism to feed sunlight to the dead rotting trees blocking the light from reaching the seedlings which will become responsible leadership someday. It has become about preservation of power, not different than other socialist/commie nations like China and Cuba. Now we must fight the enemy within and the enemy without and with far less resources so it will be a tough deal for many people to do the heavy lifting.

2008 Jul 15 01:20 PM

[GMC:]

iThinkBig: Bravo!

2008 Jul 15 01:54 PM