Yesterday, the Congressional Budget Office released its long-awaited report on the future of Fannie Mae and Freddie Mac. Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market (written by Deborah Lucas and David Torregrosa, with input from a cast of dozens — including, full disclosure, me as an outside reviewer) provides an outstanding overview of Fannie and Freddie’s history, the arguments for and against a government role in the secondary mortgage market, the flaws of the precrisis structure of Fannie and Freddie, and the pros and cons of possible reform models.
Readers may recall that last spring Phill Swagel and I proposed a reform in which Fannie and Freddie would be privatized, the government would sell guarantees on mortgage-backed securities composed of conforming loans, and that this guarantee would be available not only to Fannie and Freddie but also to qualified new entrants. (Here’s the blog version; here’s the full paper.)
CBO provides a thoughtful overview of such hybrid models:
A Hybrid Public/Private Model
Many proposals for the secondary mortgage market involve a hybrid approach with a combination of private for-profit or nonprofit entities and federal guarantees on qualifying MBSs. At its core, the hybrid public/private approach would preserve many features of the way in which Fannie Mae and Freddie Mac have operated, with federal guarantees (combined with private capital and private mortgage insurance) protecting investors against credit risk on qualifying mortgages. However, most hybrid proposals would differ from the precrisis operations of Fannie Mae and Freddie Mac in several important ways: A possibly different set of private intermediaries would participate in securitizing mortgages backed by federal credit guarantees, the guarantees would be explicit rather than implicit, and their subsidy cost would be recorded in the federal budget.14 As the public-utility and competitive market-maker models illustrate, a hybrid approach could be implemented in a way that involved more or less federal regulation of participants in the secondary market and a smaller or larger number of competitors in that market.
Advantages of a Hybrid Approach
Regardless of its exact design, a hybrid model with explicit federal backing for qualifying privately issued MBSs would have several advantages over the precrisis model, as well as over either a fully federal agency or complete privatization (approaches that are discussed below). An explicit federal guarantee would help maintain liquidity in the secondary mortgage market, in normal times and particularly in times of stress, and could retain the standardization of products offered to investors that Fannie Mae and Freddie Mac bring to that market. Compared with the precrisis model, imposing guarantee fees would ensure that taxpayers received some compensation for the risks they were assuming.
Compared with a fully federal agency, a hybrid approach would lessen the problem of putting a large portion of the capital market under government control, encourage the inflow of private capital to the secondary market, and limit the costs and risks to taxpayers by having private capital absorb some or most losses. Putting private capital at risk would also provide incentives for prudent management and pricing of risk.
Compared with a fully private market, hybrid proposals would give the government more ongoing influence over the secondary market and an explicit liability in the case of large mortgage losses that would be reflected in the budget. That arrangement might have the advantage of leading to a more orderly handling of crisis situations.
Disadvantages of a Hybrid Approach
Relative to other approaches, a public/private model has a number of potential drawbacks, the importance of which differs depending in part on the specific design chosen. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices for guarantees and probably would shift some risks to taxpayers. A hybrid approach also might not eliminate the tensions that exist—with regard to risk management and pursuit of affordable housing goals—between serving private shareholders and carrying out public missions.
Another concern is that over time, the secondary-market entities might push for broader guarantees of their product lines and attempt to reestablish themselves as too-big-to-fail institutions backed by implicit federal guarantees. Consequently, regulators would need to be vigilant to control risks to the financial system and avoid regulatory capture, while also being open to market innovations.