"Fannie and Freddie - Here Today, Gone Tomorrow - Maybe"

Sydney M. Williams

Thought of the Day

“Fannie and Freddie – Here Today, Gone Tomorrow – Maybe”

February 14, 2011

While Hosni Mubarak’s flight from Egypt dominated the weekend’s headlines, a report released by the Obama administration will have more direct impact on most people in this country. That report, “Reforming America’s Housing Finance Market”, clearly states that Fannie and Freddie strayed from their core mandate to pursue riskier business, and it points out that their “profit-maximizing structure undermined their public mission.” It essentially calls for the unwinding of the two GSEs, though one option – the third – suggests they could return under new names.

Embodied in the report are sensible recommendations to avoid future calamities: requiring higher down payments, stricter underwriting standards and promoting the concept of renting. While the report is careful about prejudicing their preferences, in suggesting that the highly popular 30-year, pre-payable mortgages without the presence of a federal mortgage company may not survive, they seem to favor option three. That option envisions a “group of private mortgage guarantor companies that meet stringent capital and oversight requirement…” – new born Fannies and Freddies?

The report offers three options – each incorporating increasing degrees of government involvement – that should be considered within the context of four key factors: access to mortgage credit, incentives for investment in housing, tax payer protection and financial and economic stability. It concludes that government should play a role in the future mortgage market, but striking a balance: “Creditworthy Americans should have broad access to credit, but not at a cost of excessive taxpayer risk, distorted markets or financial instability.” Of the three options offered in the report, the first has the government playing the least intrusive role.

Government’s involvement in markets usually results in the misallocation of capital. Capital, in such cases, does not flow based on return versus risk; it flows at the whim of Congress. A second problem, a consequence of Dodd-Frank, is that “too big to fail” financial institutions will become even larger, including those that may offer mortgages.

Regardless of what happens, the economy and the market, in fits and starts, are beginning to adjust to a future in which home price appreciation will be far more modest and homes will no longer be a source that can be tapped for consumer expenditures. Today’s article in the New York Times, “Housing Market Looks Sickest in Cities That Once Seemed Immune,” points to the continued financial risk of home ownership.

The government’s report provides a litany of causes for the meltdown; however, it does not discuss the symbiotic, and far too cozy, relationship between management and certain members of Congress. It does not put any blame on consumers who, lemming-like, often pursued mortgages beyond their means, only arguing that they need the protection afforded by the Consumer Protection Act. The report soft-pedals its criticism of the GSEs, in pointing out that delinquency rates on loans held by other banks were “far higher than on loans held by Fannie Mae and Freddie Mac,” without explaining that limits on the size of mortgage guarantees prevented FNM and FRE from participating in many of the jumbo-balloon mortgages that wrecked so much havoc.

On the other hand, as the report makes clear, far too high leverage, unrestricted salary and bonus payments made management incentives akin to those in the private sector; while risking cheap capital supplied by unsuspecting taxpayers. Some of the excess profits earned went into the pockets (or PACs) of those who were doing the regulating, a practice in the private sector that would be termed bribery.

For a time shareholders benefitted, but in the end they lost money – at least those who stuck around. The real winners were management who were grossly overpaid based on inflated numbers and politicians who saw these entities as honey pots.

The relationship between business and government, in my opinion, should be akin to that of a sports meet. The rules and regulations should be drawn up by government based upon the precept of fairness. The referees/regulators should be government. But players should represent the private sector. A problem, which the report does discuss, is that Fannie and Freddie had the “implied” backing of government, thereby reducing their cost of capital, which gave them an unfair advantage when competing against the private sector. Misallocation of capital is always a problem when the nose of government reaches under the tent of capital markets.

Institutions, such as Social Security, Medicare and Medicaid have long been considered as having “third rail” characteristics, given their ability to destroy any politician who tampered with them. Fannie and Freddie, until recently, had taken on the same mantle, as politicians from both parties pushed homeownership as a “right”. It has taken the de facto bankruptcy of the two GSEs to get government’s attention. Hopefully, a lesson will be learned, as Congress grapples with yet another new entitlement – healthcare. The lesson will not be learned if Fannie and Freddie re-emerge in disguise, and/or if Congress leaves untouched other existing entitlements.