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WebMemo #1993 on Financial Regulation

July 15, 2008

Congress Should Fix the Fannie Mae and Freddie Mac Mess

By

Sunday's announcement by the Bush Administration and the Federal Reserve seems to have cooled the immediate crisis concerning Fannie Mae and Freddie Mac. However, their plan does nothing to resolve the fundamental cause of the problem, and without major structural reforms in the housing finance industry, it is probable that this whole situation will reoccur in a few years.

While both Fannie Mae and Freddie Mac are owned by private stockholders, they are really artificial government creations that are very different from real private sector companies. Both companies are remnants of the Great Society, when big government entities were thought to be the only way to achieve social goals. The fact that both were later privatized does not change their essential nature as government-sponsored dominators of a market rather than as participants in it. Both have a history of financial and management irregularities that have caused sudden changes in senior management and often sparked congressional action. Unfortunately, these problems have not resulted in any significant reforms to the overall structure of either entity.

Background to a Crisis

Experts have warned for decades that both entities lack sufficient capital, made up of both investors' money and retained earnings, to protect against losses.[1] While most banks have $1 of capital for every $12 in assets, Fannie Mae and Freddie Mac only have $1 for every $20 in assets. Congress looked at higher standards in the 1990s, but many of the same congressional leaders who head their oversight committees today bowed to a sustained and high-powered lobbying campaign that took all the teeth out of the reform. Other reform efforts have been similarly stymied.

Fannie Mae and Freddie Mac play a dominant role in today's housing finance market by buying mortgages from lenders, packaging them into bond issues, and then reselling them to investors around the world. The two have a roughly 70 percent market share in this area, and also both guarantee mortgages and hold about $5 trillion worth of them in their investment portfolios. To operate, both entities need to borrow billions of dollars on a continuous basis. This most recent crisis was caused by concerns that an accounting rule change would sharply reduce their capital, which caused a sharp and continuing drop in their stock prices, which in turn frightened lenders and forced the government to act.

Government Stopgaps

Sunday's announcement that the government will lend Fannie Mae and Freddie Mac money through both the Federal Reserve and the Treasury -- and, if necessary, buy stock in both -- sent the necessary signal that neither will be allowed to fail. That was what the lenders needed to hear, and they promptly bought $3 billion worth of bonds from Freddie Mac on Monday. Fannie Mae plans to borrow a similar amount later in the week.

The joint action of the Administration and the Federal Reserve was important to the housing industry in general and to homebuyers in specific, since Fannie Mae and Freddie Mac provide most of the mortgage funds in today's market. If the crisis had continued, lack of cash could have dried up lending, hammering an already depressed housing sector by halting home sales in their tracks.

Even worse, the price of mortgage-backed securities would have almost certainly dropped even further, thus causing still more losses for the rest of the financial service industry. In addition, foreign governments own literally hundreds of billions of dollars worth of Fannie Mae and Freddie Mac bonds, and the shock and loss of confidence would have almost certainly led to a severe run on the dollar.

The Path to Real Reform

In the short run, Congress should:

  • Rapidly enact the proposed short-term reforms. While the Federal Reserve has the power to extend short-term financing to Fannie Mae and Freddie Mac, legislation will be required to both increase their credit line with the U.S. Treasury and to enable Treasury to purchase stock in both. In addition, lawmakers will need to exempt this temporary measure from the debt limit because otherwise, when the support of Fannie Mae and Freddie Mac ends, the debt limit would remain artificially high. These are strictly one-time moves forced by Fannie Mae and Freddie Mac's extraordinary position in the housing finance market. In both cases, Congress should act quickly in these areas to ensure that market anxiety does not resurface.
  • Strengthen OFHEO as their one regulator. The Office of Federal Housing Enterprise Oversight (OFHEO) does not have the powers that it needs to properly oversee Fannie Mae, Freddie Mac or the 12 federal home loan banks. Language strengthening the agency and giving it power to enforce decisions has passed both the House and the Senate and needs to be enacted into law. However, Congress should not agree to the recommendation that the Federal Reserve has a role in regulating any of these entities except to assess the systemic risk they pose to the economy. The long-term changes (below) will require one knowledgeable regulator that has the power to act to make sure that this situation never reoccurs.
  • Drop the Low Income Housing Fund. The housing bills passed by both the House and the Senate contain measures that assess the housing portfolios of both entities to contribute to a special fund for low income housing. Given the financial difficulties of both Fannie Mae and Freddie Mac, this provision should be eliminated.

These are important short-term moves, but in the longer run, the existing system of massive government sponsored entities that dominate housing finance should be replaced. Long-term measures should include:

  • Break up Fannie Mae and Freddie Mac. Congress needs to break up both Fannie Mae and Freddie Mac and allow them to be replaced with a much larger number of genuine private sector companies. The new, smaller companies would perform the same functions as the two current entities do, but with low and strict limits on the amount of assets the new companies can hold so that they will not have the ability to dominate the market. They could be bought, merged into other companies or even go out of business without the potential disruption that last week's crisis caused.
  • Eliminate government subsidies and preferences. After Fannie Mae and Freddie Mac have been replaced, Congress should eliminate any real or implied benefits including the line of credit with the Treasury, the ability of the government to own stock, and make it explicitly clear that there is no federal government backing for their securities.
  • Set strict standards for mortgage-backed securities. One major cause for today's financial losses and the loss of confidence in Fannie Mae and Freddie Mac has been inclusion of poor quality mortgages that are likely to default in mortgage-backed securities. Both regulators and industry need to take strict steps to ensure that quality controls can weed out low quality mortgages and properly grade these securities so that future investors can have confidence in what they are buying.

Let a Thousand Companies Bloom

Fannie Mae and Freddie Mac have caused enough turmoil due to poor management and inadequate capital. Just because the mortgage finance markets have been organized around the activities of these two entities in the past is no reason to retain that structure. Lawmakers need to take both quick actions on the short-term measures necessary to deal with today's problems and longer term reforms to ensure that this crisis cannot reoccur by breaking up Fannie Mae's and Freddie Mac's stronghold on the mortgage market. Otherwise, we will all be doing this yet again in a few years.

David C. John is Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Show references in this report

[1] Ronald D. Utt, "Time to Reform Fannie Mae and Freddie Mac," Heritage Foundation Backgrounder #1861, June 20, 2005 at: http://www.heritage.org/Research GovernmentReform/bg1861.cfm.

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