July 16, 2008

July 16, 2008 | Commentary on Economy

Fannie and Freddie: Break 'Em  Up

With the Treasury and Federal Reserve in effect promising to keep Fannie Mae and Freddie Mac afloat, the mortgage giants' crisis seems to be over. But the fundamental cause is still there - and without fundamental reform, we may very well endure a repeat performance in a few years.

Consider how Fannie and Freddie work: They play a dominant role in today's housing market by buying mortgages from lenders, packaging them into bond issues and then reselling them to investors around the world. They also guarantee mortgages and hold about $5 trillion worth of them in their portfolios. To operate, they need to borrow billions on a continuous basis.

That's fine in a bull market - but not in a bear one. Recent concerns about Fannie's and Freddie's capital levels caused a sharp, continued drop in their stocks.

That, in turn, spooked lenders - and forced the government to act.

But experts have warned for decades that neither entity has enough capital, investor funds and retained earning to protect against losses.

Where most banks have $1 of capital for every $12 in assets, Fannie Mae and Freddie Mac only have $1 for every $20. Congress looked at higher standards in the '90s, but a sustained, high-powered lobbying campaign took every tooth out of the reform.

Recall, too, that while private stockholders own both Fannie and Freddie, they're really government creations that differ greatly from true private-sector companies. That's why they're allowed to dominate mortgage securitization - and also why Fannie and Freddie need close oversight to ensure that they remain solvent and compete fairly.

Sunday's announcement - that the government, via the Fed and Treasury, will lend both entities money and, if needed, buy stock in both - sent the necessary signal that neither will be allowed to fail. That's what the lenders needed to hear, and they promptly lent Freddie Mac $3 billion on Monday. Fannie plans to borrow that much later this week.

This is vital to homebuyers: If Fannie and Freddie failed, mortgage funds would dry up, at least temporarily, halting home sales in their tracks. Plus, foreign governments own hundreds of billions of dollars in Freddie/Fannie bonds; the shock would've hurt the dollar.

But the job isn't done. Fannie and Freddie are leftovers from an era when giant government entities seemed essential to achieving social goals. The fact that both were later privatized doesn't change their essential nature as dominators of a market, rather than mere participants in it.

And this crisis is proof positive Fannie and Freddie can't continue in their current form, no matter how well they have worked in the past.

Congress should look at breaking up both. A larger number of smaller entities could compete with each other without artificially dominating the market. In other words, let's bring real capitalism to the housing-securitization markets.

The new companies would be owned by private stockholders and overseen by a regulator with enough teeth to ensure that they're safely run. They could be bought, merged or even go out of business without the potential disruption that this crisis caused. Most important, they wouldn't have the potential to bring housing lending to a screeching halt, or potentially required multibillion-dollar taxpayer bailouts.

Poor management and inadequate capital at Fannie Mae and Freddie Mac have caused enough turmoil. We need more than just stop-gap measures now to prevent the next crisis - and keep housing markets from suffering yet another blow.

David C. John is a senior research fellow in economic-policy studies at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

Related Issues: Economy

First appeared in the New York Post