Saving Freddie and Fannie?
posted by Nate Oman
Lawrence Summers has an op-ed in today’s WashPo about the housing bill’s attempt to bail out Fannie Mae and Freddie Mac. He writes:
Emergency legislation was necessary because market participants were unwilling to buy Fannie and Freddie’s debt; investors doubted that the government-sponsored enterprises, or GSEs, were healthy enough to repay it and did not draw sufficient reassurance from the implicit guarantee of federal support. If their debt proves easier to place now, it is only because this guarantee has been strengthened, not because anything has changed at the GSEs.
This, to put it mildly, is a highly problematic posture for policy. While I strongly supported the Federal Reserve’s policy response to the crisis at Bear Stearns, because it was necessary to avoid systemic risk, it is easy to sympathize with those who fear that bailouts inhibit market discipline. Consider how much more problematic the Bear Stearns response would have been had policymakers signaled their commitment to back the company’s liabilities without limit; left management in place with no change in the business model; and allowed dividends to be paid and shareholders to keep going with hope for a better tomorrow. Yet all these elements are present in the cases of Fannie and Freddie.
Summers’s proposal is for the government to take over the GSE’s liabilities (hey there is already a de facto government guarantee of Freddie and Fannie, so why not make the marriage official?), run them until the panic settles down and then dismember them and sell them off. I’m not necessarily convinced by Summers’s proposal, but I think it is worth asking what purpose Freddie and Fannie serve today.
For years Fannie and Freddie have had a lower cost of funds than ordinary lenders because of the government’s implicit guarantee of their debt. The result is that they have always been able to out compete private lenders in the core market that they have served — safe, middle-income home lending. Arguably, it was the dominance of the GSE’s in this market that pushed private firms so heavily into the subprime market, although obviously there are other factors here from the Fed’s policy to outright fraud and greed by lenders, borrowers, and brokers. Still, in an era of securitized mortgages and massive private debt markets, why exactly does the government need to play the game as shadow guarantor of safe loans, particularlly when the guarantee — as we have seen — creates huge moral hazard problems and distorts the market toward high risk loans?
July 28, 2008 at 9:19 am
Posted in: Contract Law & Beyond
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Responses (2)
Anon - July 28, 2008 at 3:51 pm
Isn’t the definition of a subprime loan one that Fannie/Freddie won’t back? It seems to me we should be thankful that a big quasi-governmental player at least forced some minimal standards on lenders involved in the loans it would back. For example, here’s Krugman on it:
http://www.nytimes.com/2008/07/14/opinion/14krugman.html?_r=1
“Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.
“Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.
“So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.”
ubeube - July 28, 2008 at 7:22 pm
Fannie and Freddie’s implicit guarantees do more than lower their borrowing cost and, as a result, the borrowing costs of new home buyers. The guarantees, combined, with their special capital requirements allow them to purchase, and efficiently guarantee (their guaranteed makes it possible for them to guarantee!) a large number of mortgages at all times.
While, the current downturn has shown this to be not quiet true, FNM and FRE have been able to loosen credit markets during past tightenings. The result being a constant availability of home-loan credit for qualifying homebuyers. Yes, this has pushed, in a sense, lenders to try and acquire larger returns by taking on more risk, but they were not forced. Without Fannie and Freddie they may have earned a slightly higher return on the loans they currently sell off to them, but they might also have been able to lend less. This might decrease the availability of home-loans and consequently the number of homes purchased . Furthermore, because of the importance of home-ownership on an average consumers ability to borrow, FNM and FRE could even be said to contribute to greater consumption.
One question that I have heard asked is why congress did not propose acquiring the GSE’s outright and continue to run them like they run Ginnie Mae (the only GSE that was not privatized). This would punish the shareholders and continue to allow the GSE’s to do the job we purportedly want them to do.
Whether or not owning a home should be part of the “American Dream”, and whether or not housing should have this important a role in our economy should are further question.
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