No Fannie, no Freddie

The Obama administration took its first, tentative step this month toward a future without Fannie Mae and Freddie Mac, the troubled mortgage finance giants. The Treasury Department laid out three options for reducing the government’s role in home loans, each of which would phase out Fannie and Freddie and shrink or eliminate federal support for run-of-the-mill mortgages. Such an approach is likely to raise mortgage interest rates, especially for 30-year fixed loans, and could make it harder to get a mortgage during a financial crisis. But it would also greatly reduce the likelihood of taxpayers being stuck covering the cost if a downturn causes foreclosures to mount.

Congress created Fannie Mae and Freddie Mac to help lower the cost and increase the availability of home loans. Before the Depression, banks typically required mortgages to be paid off in one lump sum after five years. That’s because banks’ reliance on short-term sources of money, such as customers’ deposits, left them ill prepared for the long-term risks posed by loans that wouldn’t be paid back for years.

Launched in 1938, Fannie Mae’s original mission was to purchase and hold loans guaranteed by the Federal Housing Administration. By offering banks the chance to sell the loans they issued, Fannie Mae made it possible for them to offer more mortgages and to allow longer payback periods. The eventual result was the wide availability of consumer-friendly 30-year fixed-rate loans. Freddie Mac, which Congress created in 1970, made even more capital available for mortgages by buying, bundling and selling loans to investors.

But Fannie Mae, which became a shareholder-owned company in 1968, and Freddie Mac, which has always been shareholder owned, combine public missions and private ownership in a dangerous way. Because Congress created the two companies and relied on them to promote affordable housing, investors and lenders assumed (correctly) that they wouldn’t be allowed to fail. That made it cheaper for Fannie and Freddie to borrow money, giving them an unfair advantage over competitors in the secondary market for home loans.

More important, the implicit federal guarantee encouraged the companies to take excessive risks, which they did by jumping into the market for subprime and other exotic loans late in the housing bubble. After racking up billions in profits for their shareholders and employees, they foundered in 2008, sticking taxpayers with more than $150 billion in losses.

The Treasury Department’s proposals would gradually eliminate Fannie and Freddie by reducing their holdings (they back more than $5 trillion worth of mortgages, or about half the market) by about 10% a year. The government would continue to offer mortgage support through the FHA and other agencies, but it would be narrowly targeted to qualified low- and moderate-income Americans, veterans and rural home buyers.

That’s the right starting point. Fannie and Freddie not only exposed taxpayers to unjustifiable risks; the vast pool of money and guarantees they provided led investors to commit too much capital to housing. The most visible result was the devastating losses caused after property values stopped rising. The less quantifiable effect was the diversion of investments from parts of the economy where they might have promoted more growth.

The more difficult issue is whether to replace Fannie and Freddie with some other governmental entity that would help ensure the availability of home loans, especially during financial crises. This is a crucial issue, considering that Fannie, Freddie and the FHA are buying or guaranteeing about 90% of the conventional mortgages issued during the current downturn. The Treasury’s proposal includes two ways to do so — by offering loan guarantees that would be ramped up during a credit crunch, or by reinsuring some mortgage-based securities — as well as a third proposal with no such mechanism. Either way, it’s hard to avoid moral hazards and the development of too-big-to-fail institutions.

Some housing advocates argue that without a federal agency offering to buy mortgages, the handful of big national banks that make most of the loans will end up buying, packaging and selling mortgages to Wall Street. The result, according to these critics, will be disastrous in at least three ways: 30-year fixed-rate mortgages with no prepayment penalties will disappear in favor of short-term adjustable-rate mortgages; small community-based lenders won’t be able to sell their mortgages on the secondary market, gradually driving them out of the market; and the major banks handling most of the mortgage business will grow too big to be allowed to fail.

There’s little reason, however, to believe that ending Fannie and Freddie would cause housing finance to revert to its pre-New Deal state, or that the secondary market for mortgages will shun garden-variety loans from community bankers. And a sensible, multiyear phase-out of the two companies will enable policymakers to answer these questions while Fannie and Freddie are still on the scene. The government should start shrinking Fannie and Freddie — by reducing the size of the loans that they may buy or guarantee and increasing the required down payment, in addition to selling off some of their holdings — and then should see whether mortgages grow increasingly unaffordable or homeownership declines sharply.Ultimately, the federal government’s support should be limited to helping those who can afford a home but whom the market isn’t serving. That’s a far more limited role than the one Fannie, Freddie and the FHA are playing today.