How We Could Break Up Fannie and Freddie

I hope I don’t have to defend the position for our readers that Fannie Mae and Freddie Mac are problematic institutions. They are. They were at the center of the housing bubble, and primary players in the causes of the crisis. The discussion right now is revolving around what to do with them.

Since the government doesn’t really need to be in the mortgage business (as a core function of government) in the first place, it seems the sensible thing would be to can the government-sponsored enterprises and be done with them all together. Unfortunately, most in Washington are not sensible.

However, even the least sensible people in government (historically speaking) are coming around on this issue. Rep. Barney Frank said this month: “The remedy here is…as I believe this committee will be recommending, abolishing Fannie Mae and Freddie Mac in their current form and coming up with a whole new system of housing finance.”

And even Paul Volcker, another person who has been recommending problematic fixes to financial regulations as of late, said last week: “Fannie Mae and Freddie Mac were not a good idea in the first place. This hybrid public, private thing sooner or later was going to get you in trouble — and it sure got us in trouble big time. So I hope we don’t go back to that model.”

They are both half-right. The GSEs are problems and should be abolished. But we don’t need a new model. We don’t need a new system. But even if we could come to a consensus on that point (which we won’t) the question of what to do with Fannie and Freddie still remains.

The process of ending the GSEs is complicated and hotly debated. In the short-term, the GSEs can’t be shut down overnight, since virtually the entire mortgage market is dependent on them right now as a waste basket for toxic mortgage debt. But that doesn’t mean a long-term strategy for restructuring Fannie Mae and Freddie Mac can’t be put into place now.

The first option for fixing Fannie and Freddie would be to break them up into pieces and sell off parts of their portfolio over a period of time, say three to six years. The prime mortgage securitization businesses and the conforming mortgage portfolios would be the first things to go. Over the next decade, a market for the subprime debt, currently being bought up by the Federal Reserve, would form with investment from private equity and hedge funds. Any government related activity related to promoting low-income housing would be consolidated into the FHA, HUD, and Ginnie Mae.

A second option involves slicing the GSEs up into a consortium of institutions co-owned by banks and originators on the same model of the Federal Home Loan Bank System that lends money to banks for mortgages and small business loans. The FHLBS-model would remove taxpayer exposure, and reduce risky loans since mortgage originators would have a vested interest in the health of the consortium. In this case low-income housing policy would also fall to other agencies. Regulators would need to ensure this model doesn’t just break two big problems into several small ones though.

Some will argue a third option of simply forcing Fannie and Freddie to consider solvency first before profit, to require 20 percent down, to only back first liens, and avoid ballooning adjustable rate mortgages. But in the end we wouldn’t be able to control them any better than the past forty years. Especially if their mission remains to skew the housing market with a federal too-big-to-fail guarantee. Still others argue that the GSEs should remain, but only as mortgage securitization agencies, guaranteeing credit risk. This makes little sense since excessive risk was their kryptonite in the first place.

The government will have to fight the urge to replace Fannie and Freddie with some other organization to “help” the housing market. But if other programs designed to help homeowners, such as the First-Time Homebuyer Credit, are cut and the housing market is allowed to find its real bottom for prices then the market will see a return of new real estate investment anyway. In the end, we don’t need Fannie Mae and Freddie Mac. Their existence only exacerbated risk-taking and served as a vehicle for Congress to manipulate mortgage funds to appease local voters.