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The two giant providers of cash for mortgages now back almost 9 out of 10 home loans. Fannie, founded during the New Deal as a federal agency and then converted into a shareholder-owned government-sponsored enterprise in 1968, had its most profitable year in 2012. Together, the entities paid the U.S. Treasury $66.3 billion in dividends on July 1 — a sum that extended the debt-ceiling deadline by a month.
Now, policy makers are poised to eliminate the GSEs’ roles in home mortgages. They have some justification: Fannie and Freddie distorted their books and loaned recklessly in the middle of the last decade. (They weren’t the only guilty parties, of course. This week, JPMorgan Chase & Co. (JPM) agreed to a tentative $4 billion settlement with the Federal Housing Finance Agency for misleading the GSEs in their purchases of mortgage bonds.)
Worst of all, Fannie and Freddie gave the green light to other investors to follow their lead. Even former Representative Barney Frank, a Massachusetts Democrat and GSE cheerleader, concluded in 2010: “I hope by next year we’ll have abolished Fannie and Freddie. … It was a great mistake to push lower-income people into housing they couldn’t afford.”
Never mind that it was legislators such as Frank who were doing the pushing. In return for an implicit federal guarantee on their debt, Fannie and Freddie were pressured by Congress to take on various social responsibilities — such as funding subprime mortgages — that conflicted with their financial responsibilities.
Some kind of reform is necessary, but policy makers should be careful not to destroy the parts of the GSEs that work as they seek to expiate their own political sins. They also need to avoid solutions that needlessly raise the cost of borrowing for homeowners. In addition, they should be aware of the adverse effects on the financial system that would be caused by the seizure of private property — in this case, securities held faithfully by those investing in a turnaround that, eventually, occurred.
Last year, in a breathtaking display of greed, the Treasury and the FHFA changed the terms of the original agreement that accompanied the 2008 bailout, which gave the Treasury 79.9 percent of the GSEs’ stock and required a rich 10 percent annual dividend payout.
That payout wasn’t enough for a government running trillion-dollar deficits. The dividend was replaced by a quarterly “net worth sweep” that gives the Treasury almost the entire net worth of Fannie and Freddie’s balance sheets. The sweep, Treasury said, will suck up “every dollar of profit each firm earns going forward.” (See the $66.3 billion dividend three months ago.) The two GSEs have already repaid $132 billion of the $188 billion they received. The rest should be paid by the end of 2014, but the sweeps will go on and on.
The changed payout arrangement prevents the GSEs from rebuilding their capital and deprives private shareholders of the value from their investments.
Many in Congress approve. Representative Jeb Hensarling, the Texas Republican who leads the House Financial Services Committee, has offered a measure that would officially kill off Fannie and Freddie. It would use new federal agencies to set rules for the private securitization of mortgages and help first-time buyers.
A bill by Senators Mark Warner, a Virginia Democrat, and Bob Corker, a Tennessee Republican, would replace the two GSEs with a mortgage insurance fund that resembles the Federal Deposit Insurance Corp. In August, President Barack Obama indicated he was leaning toward the Senate version.
Both bills, however, would have serious negative consequences:
- They require outright — as opposed to implicit — backing for all of the GSEs’ outstanding debt and mortgage-backed securities, with the “full faith and credit of the United States.” As Karen Shaw Petrou of Federal Financial Analytics Inc. told the American Banker: “If you give Fannie and Freddie that explicit guarantee for all their existing obligations, what’s the budget impact of that? It’s huge.” Fannie has $3 trillion in debt on its balance sheet; Freddie, $2 trillion. Those would become government liabilities.
- Neither measure adequately addresses mortgage liquidity, which was the reason that both Fannie and Freddie were established. With the lenders gone, it’s unclear what would fill the gap. Private sources originated just 14 percent of home loans in 2012, down from 67 percent in 2006.
- The bills would increase loan payments for consumers. Mark Zandi, chief economist of Moody’s Analytics Inc., calculated that each of the congressional proposals would add $900 to $1,050 in annual interest for a $200,000 home loan. “You have to assume that almost in any future model being drafted, loans will be more expensive,” said David Stevens, chief executive officer of the Mortgage Bankers Association.
- Neither bill addresses what happens to the private investors in Fannie and Freddie, including the community banks and insurance companies that were encouraged by their regulators to bolster the GSEs’ capital. The threat of government confiscation is precisely the wrong message to be sending investors. Even Ralph Nader has cried foul, complaining that federal policies have turned shareholders such as him into “zombies.” The GSEs’ investors have filed 10 separate lawsuits seeking damages from the takeover, and U.S. District Judge Robert Wilkins consolidated the cases on Oct. 9.
A better, simpler solution would be to end the federal guarantee — explicit or implicit — and allow Fannie and Freddie to rebuild their capital. The GSEs served a highly constructive purpose until they became political institutions. They can play an even more important role without special benefits, providing liquidity while encouraging private competition on a level playing field. The government should sell its GSE holdings at a profit, provide a strong regulator, and treat Fannie and Freddie like Citigroup Inc. or any other large financial company.
Politicians should promise to stay away. That won’t be easy for them, but rather than devising plans for sweeping reorganizations, it is exactly what is demanded of Congress.
(James K. Glassman, a former undersecretary of state, is a visiting fellow at the American Enterprise Institute.)
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