The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.
The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.
Our proposal, “Whither Fannie and Freddie: A Proposal for Reforming the Housing GSEs” has just been released.
Here’s the gist:
The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.
Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.
How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.
P.S. For a nice overview of the Fannie & Freddie situation, see this article by Nick Timiraos in the Wall Street Journal; it includes a brief mention of our plan.
Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.
Interesting, Don. Thanks for sharing this idea. I have a couple of questions regarding the proposal.
“To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee”
This sounds like it might end up similar to the PBGC “guarantee” with Congress setting “actuarially fair” (low ball) fees and providing a false sense of security for taxpayers. How great is the risk that politics triumphs over good policy with this proposal?
Would breaking up Fannie and Freddie into units large enough to compete efficiently and effectively while transforming the system from “too big to fail” to “too small to require a Federal bailout in order to guard against systemic risk” make more sense? A market with smaller firms may spontaneously create a private insurance market, sparing future taxpayers from the risk caused by the all too familiar moral hazard caused by government guarantees.
Given the tendency for politics to triumph over policy in Washington DC, I suspect any proposal that connects mortgage guarantees to the taxpayer will eventually impact the taxpayer negatively.
Best regards,
Scott
Hi Scott — Sorry for being slow to respond. Yes, charging an actuarially-fair fee would put this in the same general ballpark as PBGC, flood insurance, FHA, etc. There are clearly limits on the government’s ability to charge real, actuarially-fair premiums in those programs. Our point is simply that it’s much better to do that than the old Fannie and Freddie system in which there were no premiums whatsoever. We’d definitely like to see more players in the market, which reduces certain kinds of risks. It’s not clear (to me at least) whether that can be done by slicing up the existing firms. But another strategy is to allow entry.
‘Fair fee’ – that’s something as mythical as ‘fair price’, isn’t it? I don’t think ‘fair’ is an economic category; turning ‘market’ values into ‘fair’ values has always caused troubles at the end of day…