July 15, 2008 | WebMemo on Financial Regulation
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. 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.
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:
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:
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.