Though Congress is now considering tighter regulation of Fannie Mae and Freddie Mac, there are reasons to doubt that tougher regulation alone can protect the economy from the risks associated with these two government-sponsored enterprises. Privatization seems to be the only solution that will wholly eliminate them.
To be sure, the objections to privatization raise serious issues. Some argue that it would disrupt the residential finance market and drive up home mortgage rates. Others believe that if Fannie and Freddie were shorn of their government support they would become dominant players in the mortgage market simply because of their size--which would also make them too big to fail.
These objections are overcome in two complementary plans developed for the American Enterprise Institute and outlined in its recent publication Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How.
The first, from Thomas H. Stanton, shows how to privatize the GSEs without disrupting the mortgage markets or leaving Fannie and Freddie as the dominant players in residential finance after privatization. The second, from Bert Ely, shows how to achieve lower mortgage interest rates than Fannie and Freddie now offer, without any government backing.
The key to Mr. Stanton's proposal is that Fannie and Freddie immediately stop making portfolio investments in mortgages and mortgage-backed securities and then liquidate their existing portfolios gradually over five years.
So as not to disrupt the mortgage markets, Fannie and Freddie could keep securitizing mortgages and issuing mortgage-backed securities for six months. Then they would have to begin turning over their securitization activities to subsidiaries of private-sector holding companies they would be permitted to form.
The GSEs could make this handoff only after they had spun off their automated underwriting systems and mortgage databases to independent companies for licensing at market rates to all comers.
Five years after the plan's enactment, all of Fannie and Freddie's securitization activities would have been fully transferred to their private-sector subsidiaries and the GSEs would no longer hold any mortgages or mortgage-backed securities. At that point their federal charters would be terminated, all their remaining assets would be transferred to their holding companies, and all their remaining liabilities would be defeased.
Mr. Ely's financing plan would modify banking regulations to make it profitable for subsidiaries of banks and bank holding companies to hold mortgages as investments rather than sell them in the secondary market.
This is difficult today because banks, bank holding companies, and their subsidiaries are subject to a leverage capital requirement that substantially increases the capital cost of holding home mortgages.
Under Mr. Ely's plan, applicable regulations would be revised so that banks and bank holding companies could establish mortgage holding subsidiaries, exempt from leverage requirements, that could profitably hold mortgages originated by their affiliates or others.
The mortgage holding subsidiaries would not take deposits, and their capital would be fully deducted from that of their parent bank or bank holding company, so adverse financial results would not affect the parent's capital position. Under these circumstances, there would be no reason for a leverage capital requirement.
By using these subsidiaries as repositories for the mortgages they originate, banks and bank holding companies could realize substantial savings on origination costs.
These savings could reduce the all-in cost of a home mortgage (origination costs plus interest) below the rates now available through Fannie and Freddie--and without any government backing.
At a time when new disclosures raise serious doubts about the true financial condition of Fannie Mae, a practical privatization plan may be a better alternative than tighter regulation.
Peter J. Wallison is a resident fellow at the American Enterprise Institute.