The Fannie and Freddie Conservatorship Cannot Last Forever

Time to end the taxpayer guarantee of mortgage investors

It is time to reform the housing finance system. Frankly, it was time three years ago when Fannie Mae and Freddie Mac (GSEs) were taken into conservatorship (a fancy way for the government to avoid technically declaring them bankrupt) back in August of 2008. Really, it was time in the early 2000s when the GSEs were going through an accounting scandal and contributing to the housing bubble with their low underwriting standards. Okay, yes, reform was ripe back in 1986 too when the Reagan administration failed to address the deduction of mortgage interest as a part of its broader tax reform.

In short, it has been time to fix government policy towards housing finance for decades, yet no Congress or president has been able to rise to the challenge.

On Tuesday, Fannie Mae announced it lost an additional $5 billion in the third quarter and will require an additional $7 billion from taxpayers. This brings the total taxpayer bailout for the two mortgage giants to an eye-popping $182 billion. Against this backdrop, the chief housing regulator in this country, Ed DeMarco, provided some new fuel to the reform debate when he testified before a House subcommittee last Friday. Noting the difficulty of housing finance reform, Mr. DeMarco warned the GSEs “cannot operate indefinitely in conservatorship” and that “despite the benefits derived from the Treasury support … conservatorship is not a long-term solution.”

At least someone gets it.

Unfortunately, Mr. DeMarco’s current mandate is only to oversee the housing behemoths Fannie Mae and Freddie Mac and to limit taxpayer losses. It’s up to Congress and the president to reform the system. Hopefully with the new public awareness over all the taxpayer losses and bailouts – and the millions Fannie and Freddie employees continue to take home in pay – policymakers will be encouraged to finally act.

A number of proposed solutions have been put on the table, from phasing out the two government enterprises over a five-year period and allowing future mortgages to be financed without subsidies to chartering a new government agency that would explicitly guarantee returns for mortgage investors and subsidize the costs of mortgage credit.

More recently, Rep. Scott Garrett proposed having Ed DeMarco and his colleagues at the Federal Housing Finance Agency design a few standardized mortgage categories to make the private mortgage market more transparent and liquid, so that it does not have to rely on any government guarantees. At the very least, the status quo needs to change. As DeMarco argues, “There seems to be relatively broad agreement that the government-sponsored enterprise model of the past, where private sector companies were provided certain benefits and charged with achieving certain public policy goals, did not work.”

Nevertheless, DeMarco did note that realistically, “there will always be some portion of the housing or mortgage market that will be assisted by government programs, either through direct funding or through guarantees.” The challenge for policymakers is to determine whether or not, and then to what degree, they want to use public resources to subsidize housing for particular groups in society.

For instance, the federal role could be limited to providing financial assistance to just those with incomes below a certain threshold, while the rest of the housing market is financed by investors who don’t need a government crutch.

The value of avoiding government guarantees came across as strongly as a figure in DeMarco’s position could convey. After spending the past few years intimately observing Fannie Mae and Freddie Mac, he warned that “replacing the Enterprises’ implicit guarantee with an explicit one does not resolve all the shortcomings and inherent conflicts in that model, and it may produce its own problems.”

Even though a guarantee for mortgage-related securities would create more liquidity, “those securities would not have the benefit of market pricing for credit risk of the underlying mortgages,” DeMarco said. “This type of structure requires a significant amount of regulatory safety and soundness oversight to protect against the moral hazard associated with providing a government guarantee,” he continued. Put another way, what he is saying is that the investors’ payments would come through irrespective of the performance of the underlying mortgages. This eliminates the incentive for market participants to ensure the mortgages that make up the collateral pool are of high quality.

DeMarco concluded his testimony by making a few key observations, including this profound statement and question: “The presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider reasonable, or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better. If the government backstop is underpriced, taxpayers eventually may foot the bill again.”

If the government did extend a new explicit benefit, DeMarco noted that in exchange it would certainly seek to direct some of the liquidity it created towards social or geographically significant parts of society, risking “further taxpayer involvement if things do not work out as hoped.”

DeMarco further warned that any explicit guarantee for more than a “small portion of mortgages” would, like the mortgage interest deduction, direct more capital towards housing than would otherwise be invested. This reduces the value of subsidies by pushing up the cost of housing – in short, if everyone is subsidized, no one is. DeMarco leaves it to policymakers to decide whether or not this is a good idea, but it stands to reason that since one of the causes of the housing bubble was an oversupply of capital – whether or not it was Washington’s or Wall Street’s fault – incentivizing such behavior again would be unwise.

With all of the cards on the table, there is no reason that policymakers should hesitate to push forward with housing finance reform. The argument that a fragile housing market should be left alone because any action could trigger a host of unknown problems is illogical. Doing nothing now still reflects a choice, one that assumes the status quo system is not hurting the housing market or the economy. In addition, Congress could tackle housing finance reform tomorrow but set a transition schedule in the legislation that would enable careful monitoring of market conditions.

If the status quo is the system that policymakers want, then they can leave it alone. But if members of Congress see the need for some action upon observing the crumbling state of American housing finance, then the time to move on it is now. In fact, a strong case can be made that a recovery in real estate is dependent on clear rules and expectations for how the housing finance system will work in the future. After all, it’s only with a new legal regime that all the key stakeholders – households, businesses and investors – can make the informed decisions that are necessary to start a housing recovery.

Christopher Papagianis is the managing director of Economics21, a nonpartisan policy-research institute, and previously was special assistant for domestic policy to Pres. George W. Bush. Anthony Randazzo is director of economic research at the Reason Foundation.

This commentary first appeared at The Daily Caller on November 10, 2011.