June 23, 2005

June 23, 2005 | Commentary on Smart Growth

Flawed Fannie Mae reforms put taxpayers and markets in jeopardy

In late 2004, federal regulators charged Fannie Mae with a series of questionable accounting practices that had caused an overstatement of earnings and an understatement of risk.

Although Fannie Mae denied the accusations, a review by the Securities and Exchange Commission confirmed them. Within a few weeks, its top officers had resigned.

Congress responded with a series of extensive hearings, and in May the House Committee on Financial Services reported out H.R. 1461, a bill lawmakers said would rectify the problem by creating new regulations.

Fannie Mae's private-sector competitors and White House officials, though, say the proposals are too timid and would leave the institution operating in a less restrictive regulatory environment. Plus, the new regulations would sustain the powerful co-monopoly position Fannie Mae shares with its sister government-sponsored enterprise (GSE), Freddie Mac, which suffered its own accounting lapses in 2003.

The new proposal also would require the GSEs to use a portion of their profits (5 percent) to fund "affordable" housing programs in a clumsy effort to contrive a costly public purpose to enterprises that long ago outlived any justification for the valuable privileges the GSEs receive from the federal government - chief among them emergency access to U.S. treasury and Federal Reserve credit.

Many in the global financial markets view this potential access to federal credit as providing an implicit federal guarantee to their debt - a guarantee that allows the GSEs to borrow at interest below the best private corporations and slightly ahead of what the U.S. treasury pays.

Lawmakers failed to address those broader issues of privilege because they focused on Fannie Mae's Enron-like behavior instead of its market power. By controlling half the residential mortgage market, the GSEs deter competition and force the housing and housing-finance markets to rely on two financially unstable co-monopolists.

With such market power concentrated in the hands of two institutions, the stability of U.S. financial markets could be undermined by financial problems in just one of them. Taxpayers would be on the line if a bailout were required. GSE defenders contend such risks are remote and offset by the benefits that GSEs provide the housing market, but critics contend those benefits are grossly overstated.

While there are many studies that question the impact of GSEs on homeownership or home construction, broad mortgage and housing-market trends over the past several decades reveal their limited influence. America's greatest surge in homeownership, for example, took place between 1946 and 1960, when the homeownership rate jumped from no more than the mid-40-percent range at the end of World War II to 62 percent in 1960, a period during which Fannie Mae's activity was limited and Freddie Mac didn't exist.

In 1965, when the GSE and other federal programs accounted for 6 percent of the mortgage market, America's homeownership rate was 63.3 percent. By 1990, after outstanding residential mortgage credit expanded more than tenfold, and when the federal and GSE presence in the residential mortgages grew to nearly half the market, America's homeownership rate was at 63.9 percent, an improvement of less than 1 percent.

With benefits modest and market risk considerable, a better reform is to phase out the significant federal credit privileges the GSEs possess, allowing them time to adjust to a more competitive environment. To implement this orderly withdraw of federal support:

  • The U.S. Treasury should phase out the GSEs' line of credit over a five-year period in annual increments of $500 million for each GSE.
  • Congress should immediately eliminate the Federal Reserve's authority to buy GSE debt.
  • The GSEs should lose their exemption from state and local income taxes.

As these reforms are under way, the GSEs' skilled work force could concentrate on securing residential mortgages in a fair and open competition with dozens of new entrants from the private sector who would be attracted to the market by the level playing field such deregulation would offer.

If the GSEs are as effective as they claim, they would welcome such a contest. But don't bet the house on it.

Ron Utt of Falmouth is a senior research fellow at the Heritage Foundation.

About the Author

Ronald D. Utt, Ph.D. Herbert and Joyce Morgan Senior Research Fellow

First appeared in The Hill