The re-nationalization of mortgage insurers Fannie Mae and Freddie Mac presents a serious challenge to national housing policy. But it is important to note that the failure of Fannie Mae and Freddie Mac is not an example of privatization gone amok; it is an example of what happens when privatization doesn’t happen in the first place.
Despite all appearances, the firms were never really private; rather they operated as anomalous “government-sponsored enterprises.” As GSEs, Fannie and Freddie had stockholders, boards of directors, and made profits from interest on the loans they securitized. However, their profit motives were skewed by their beliefs (correctly) that the government would cover any big financial losses. Like playing poker with someone else’s money, you’re more likely to place chips down on a risky bet if its only pride you have to lose. This fundamental flaw inherently them from being fully private companies.
When Fannie Mae was ‘privatized’ in 1968, and Freddie Mac created to compete with it in 1970, they were tasked with a simple mission: insure and finance mortgages to low- and middle-income families with good credit histories. These firms had the good intentions of getting good people into good homes that otherwise didn’t meet the credit standards of corporate America. But good intentions don’t defeat bastardized incentives on risk.
If Freddie and Fannie had stayed true to their missions, they would not be in this mess today. Somewhere along the line, their executives decided to begin taking on riskier mortgages in order to grab a slice of the subprime mortgage market and the profits that looked, at the time, to be a never-ending pool of interest payment money. However, when many of those loans blew up, they were left with nearly $5 billion in debt and no collateral to cover it.
Sure, they met part of their mission to help low-income families, but also backed mortgages made to borrowers who didn’t fully document their incomes or had no assets.
The more Fannie and Freddie strayed from their mission to finance those with good credit histories, the more bad debt they took on. Whether or not GSEs are appropriate for government, Freddie and Fannie defrauded the American taxpayers by setting themselves up for losses they had no business going near. They certainly would have suffered some losses from the sheer size of the housing bubble, considering that between the two of them they own $5 trillion of the $12 trillion in outstanding mortgages. But they wouldn’t have been bitten by the subprime bug.
Financial analysts accuse Daniel Mudd and Richard Syron, former chief executives of Fannie and Freddie respectively, of being greedy for extra profits. They undoubtedly made poor decisions and are partially to blame. Yet, it is the goal of any business to maximize profits while taking the appropriate risks. Because of the perverse system in place, Mudd and Syron had little risk. They knew they had a government safety net to back them up, whether they were outside their mandate or not.
These perverse incentives are just on reason that free market groups, like this one, called for the privatization of Freddie and Fannie for years. It was clear to everyone that they were merely “quasi-private” with their GSE status. In February 1995, Reason’s Bob Poole suggested they be fully privatized in a Reason magazine article. Many others warned for decades that taxpayers might get caught with a large bill if Fannie or Freddie encountered financial crisis. Conjecture has become reality, and it is American taxpayers who are suffering the consequences.
Businesses can only succeed with the proper profit motives to guide and restrain them. The hopeful future privatization of Fannie Mae and Freddie Mac should carefully weigh this reality in determining the proper course of action.