Reforming the GSE Maes and Macs Starts with Accounting Honesty

In a Wall Street regulation overhaul plan released last month by Congressional Republicans, the GSEs Fannie Mae, Freddie Mac, and Ginnie Mae would all be sentenced to death. The plan called for a 10 to 15 time frame for winding down the institutions and getting them off the government’s books. This privatization would be welcome, though is too slow for my tastes. The White House left out GSE reform in its plan to overhaul regulation, but has since announced at least an idea, though not quite a plan.

The idea is to take all of the bad mortgage bets the GSEs made and stick them in a bad bank style holding company. This “Baddie Mac” (if you’ll pardon the pun) would work out the toxic debt over time, leaving clean Fannies and Freddies to pursue positive growth again. But this is not privatizing the firms. This reform is keeping the debt in taxpayer hands, the toxic debt worked up overtime by institutions who assumed (correctly) that any failures would be caught by a public security net. Recreating these moral hazards, and letting the private sector invest in them again on the assumption (read: “reality”) that their investment is backed by the full faith and credit of the US government is only going to recreate the problem.

Washington needs to deal honestly with the mortgage originating giants. The GSE model isn’t a good one. It won’t last over time. And it currently is weighing down the entire country (not to mention distorting the housing market).

The reality is Fannie and Freddie are costing the taxpayers a lot of money right now. They should be (but aren’t) listed on the federal balance sheet. They are technically 80% owned by the Federal government with $1.5 trillion pledged as support if necessary. The Wall Street Journal editorialized this morning:

Mr. [Larry] Summers has long said that mixing private profit with public risk is bad policy, and we trust he doesn’t want to repeat the mistake. A starting point for permanent reform would be to treat Fan and Fred, in the budget and on the federal balance sheet, as the government-owned creatures that they are. For the moment, despite 80% government ownership, their $85 billion bailout cost (with more losses to come) and their $5.4 trillion in taxpayer liabilities remain off-balance-sheet in the mold of Enron’s special purpose vehicles or Citigroup’s SIVs.

The politicians who created and pampered Fan and Fred like it that way. They know that offering federal “guarantees” looks much cheaper, in the official accounting, than actual outlays. But whether it’s Fan and Fred, or the Pension Benefit Guaranty Corporation or the Federal Housing Administration, these deferred promises seem to come due sooner or later. Perhaps the politicians would be less profligate in issuing such guarantees if they had to admit the cost up front.

Putting Fannie and Freddie on the national books would in an instant increase the national debt held by the public by 75%—to $12.7 trillion, from $7.3 trillion today. The nearby chart shows that this takes debt as a share of GDP to nearly 90%, or nearly double the peak it reached in the 1980s when the political class was hyperventilating even as the Reagan deficits were falling as a share of GDP. Congress would have to add that $5.4 trillion to the increase in the federal debt limit that Treasury Secretary Timothy Geithner is now requesting. But that would be truth-in-budgeting. Wall Street has sold Fannie paper to the world as if it were as taxpayer guaranteed as Treasury bills, and now we know it is.

Reform starts with addressing the GSEs straight up. They are a part of the government’s budget problem right now. And shifting around the bad debt only creates more columns on the national balance sheet—it doesn’t make the problem go away. Breaking up the GSEs and selling off their parts to the private sector does relieve the burden on the taxpayers. The administration, and in particular OMB director Peter Orszag, should seriously consider adjusting the accounting practice for this debt and emphasize just how big this problem is. Then maybe some real reform can come.