The Fate of the Mortgage Monsters

A great diagnosis of Fannie and Freddie, a weak prescription

When Massachusetts Rep. Barney Frank, a Democrat, began calling for the closure of Fannie Mae and Freddie Mac last year, it signaled the beginning of the end of the two mortgage giants. But Frank, the former patron saint of the two so-called government-sponsored enterprises, has done nothing to start the process of shutting down the GSEs, and Congress is just now starting to address the issue.

In Guaranteed to Fail, a quartet of New York University professors from its Stern School of Business focus on the “debacle of mortgage finance” that Fannie and Freddie helped create, and offer a plan for reform. In clear language, and with plenty of data to support their arguments, the authors provide a concise but comprehensive history of the GSEs-which alone makes their book worth reading.

They also demonstrate that Fannie and Freddie were indeed “guaranteed to fail” when they were launched as semi-private government-sponsored enterprises four decades ago. “If the government was Doctor Frankenstein,” they write, “surely the GSEs were its monster. Born of a well-intentioned…goal of creating liquidity in the secondary mortgage market, these institutions morphed into typical profit-making firms with an important exception-the government served as the backstop for the majority of their risks.” The lethal combination created moral hazard-risky behavior by institutions insulated from the consequences of that risk.

Government guarantees created an unstable mortgage market, underpricing risk and driving excessive investment in housing and mortgage-backed securities. The GSEs became a major cause of the housing bubble and subsequent economic collapse, with the resulting bailout costing taxpayers $150 billion so far-a tab likely to climb much higher.

It’s surprising, then, that the NYU professors end up arguing for a hybrid mortgage-finance system anyway, where the government continues to provide the majority of guarantees. Their proposal includes winding down Fannie and Freddie, and replacing them with a government agency that will be set up to provide capital to private mortgage insurers. In this system, financial institutions that package mortgages as securities would have to purchase insurance from a private guarantor, but most of the capital supporting that insurance would come from the government.

The authors attempt to get around the inability of government to price risk properly by having the private mortgage insurers set the price of insurance, with the government agency collecting fees for its support, based on that price. To try to protect taxpayers, only mortgage-backed securities with sound underwriting standards would be eligible for government-supported insurance.

Now, as hybrid plans for reforming Fannie and Freddie go, this is one of the best. Far worse proposals include nationalizing mortgage lending completely, or allowing the big banks to take over all mortgage lending by regulatory fiat. But one big flaw is that their plan does not meet the authors’ own goals for reform.

They define an efficient housing-finance system as one that does not engender moral hazard, corrects market failures, limits concentrated risk and allows the market to appropriately price risk. But it is in the nature of government guarantees to promote the underpricing of risk, since their fundamental goal is to encourage more investment than would otherwise occur.

While this system may spread risk around effectively, it would still not be priced correctly. There is no way private guarantors will offer the correct price for their risk knowing that as much as 75% of their capital is coming from Uncle Sam. Investors may have the incentive to perform more due diligence, since they would not be 100% guaranteed if the private guarantor became insolvent-and they would still have taxpayer support, which would distort their investment decisions.

The authors acknowledge this problem-which is one reason they propose that the guarantee system be wound down after 10 years. But this seems politically naive. Programs like this do not disappear easily in Washington, where many things can change, often for the worse.

If the political debate over housing finance reaches an impasse where a guarantee system is inevitable, then this proposal deserves a hearing. But there are better ways to reform the market for housing finance. Still, as diagnosis rather than prescription, Guaranteed to Fail succeeds as valuable reading.

Anthony Randazzo directs economic research for Reason Foundation.

This article originally appeared in Barron’s newspaper on April 4, 2011.