Fannie and Freddie, Please Don't Change!

Two gigantic companies, Fannie Mae and Freddie Mac, contributed to the housing crash and the near collapse of the banking system. So, now that we are reforming the financial system, what should we do to punish or reform these two mortgage giants?

Nothing, for the most part. Fannie Mae and Freddie Mac should continue to operate the way they do today.

Now, before you rush to leave an angry comment, consider this: The most important reform that we could possibly make to Fannie Mae and Freddie Mac has already happened, and there's a serious risk that Congressional "reform" will undo that change.
In August 2008, the government took control of Fannie Mae and Freddie Mac. The shareholders, the people that used to own the companies, lost their investment. And so far, the government seems to have no plan to give control of the companies back to the shareholders.

Sure it's still possible to buy a share of Fannie Mae or Freddie Mac stock, but the price tells the story: At roughly $1 a share, Wall Street is betting that the shares are worth about as much as lottery tickets.

That makes Fannie Mae and Freddie Mac unique: Of all the companies that received government handouts during the bailout season of 2008, Fannie and Freddie's owners are the only ones that lost their companies. That's a wonderful thing --and not just because it avoids the moral hazard of bailing out people who own bad corporations.

Until the government took over in 2008, Fannie Mae and Freddie Mac suffered from conflicting motivations--each served two masters. They had a mission from Congress to promote home ownership with the implicit backing of the federal government and with the power to borrow as much money as they needed at low interest rates.

But Fannie and Freddie also had a responsibility to make as much money as they legally could for their shareholders, which led them to use their borrowing power in risky ways similar to the games played by hedge funds or bailout banks during the boom.

For example, back in the boom years, Fannie Mae and Freddie Mac used their borrowing power to buy hundreds of billions of dollars in bonds. At the time, Fannie and Freddie told Congress they were fulfilling their housing mission, because the bonds were often backed by (subprime) home mortgages or loans to apartment buildings. But really they were acting like hedge funds, buying risky things with borrowed cash and passing the profits on to their shareholders in fat dividend checks.

It's these risks that brought Fannie and Freddie down, not their regular business of guaranteeing loans. (Here's an analysis of the risks Freddie Mac took based on documents from the company.)

Today, Fannie and Freddie are under the orders of the Federal Housing Finance Agency. They have all the same powers to borrow vast sums that they had during the housing boom - but without the need to churn out dividends to please shareholders, Fannie and Freddie have no motive to make the kinds of mistakes made by hedge funds or bailout banks.

This summer, Congress will face a huge temptation to once again sell Fannie Mae and Freddie Mac to private investors. A new sale of Fannie Mae and Freddie Mac stock would raise billions to offset some of the government's estimated $85 billion in losses from its support to Fannie and Freddie so far.

Congress would probably combine this sale with a lot of tough talk and harsh-sounding restrictions on what Fannie and Freddie can and can't do with their incredible power to borrow money and nearly total dominance of the mortgage market. But as long as Fannie and Freddie had the nearly total backing of the federal government and a responsibility to maximize returns for their shareholders/owners, I'm not sure any regulation would be strong enough to keep them from pushing risk.

Where there's a will, there's a way.
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