The Case for Cutting Fannie and Freddie Loose

Includes: FMCC, FNMA
by: Zubin Jelveh

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?