Fannie and Freddie: Grow up

Not immediately, but at some time in the foreseeable future, Fannie Mae and Freddie Mac must be either officially nationalized or fully privatized. We vote for fully privatized. Let’s cut the apron strings that tie them to the taxpayers’ wallets and get government out of the business of guaranteeing securitized mortgages altogether. It is inappropriate for the U.S. taxpayer to be standing behind these two for-profit enterprises, helping to protect the shareholders from the poor and risky business practices of its management.

Other countries have healthy real estate markets without anything like Fannie Mae of Washington or Freddie Mac of McLean, Va., providing government guarantees of mortgage-backed debt.

That implied government guarantee not only contributed to the mortgage meltdown but now has taxpayers on the hook for as much as $5 trillion of mortgage debt.

The existence of Fannie and Freddie encouraged mortgage lenders to lower their lending standards continually, knowing that they wouldn’t lose if the mortgagees defaulted, because Fannie or Freddie — or those who bought securities backed by the mortgages — were holding the paper.

The implied government guarantees allowed Fannie and Freddie to borrow in the capital markets at low, near-Treasury rates and generated huge profits for shareholders.

Those huge profits encouraged investment banks to begin securitizing mortgages and selling them to investors in competition with Fannie and Freddie, further fueling the housing boom.

The problem with nationalizing Fannie and Freddie is that the government would have to recognize formally an additional $5 trillion of national debt, driving it up more than 50% to almost $14 trillion.

Ironically, Fannie was privatized during the Johnson administration to get it off the federal budget and to keep its debt off the federal balance sheets. Freddie was started to provide competition for Fannie.

It isn’t clear that Congress will be willing to nationalize the two enterprises and thus recognize the debt. Besides the national debt issue, Fannie and Freddie have many friends in Congress who could forestall any changes.

If the two are to be privatized, it will have to be done over time and after the financial crisis has passed.

Any action now that throws the future of Fannie and Freddie into question will roil the financial markets not only in the United States but also overseas, because financial institutions around the world hold their debt and equity.

The best strategy is for the government to move cautiously, refrain from any action that might spook the markets and allow the mortgage market to recover. If that can be achieved, the ultimate cost to taxpayers of the government guarantee might be significantly less than $5 trillion.

In the meantime, the Department of the Treasury can examine how best to privatize the two enterprises at the least cost to taxpayers.

One idea from Alex J. Pollack, resident fellow at the American Enterprise Institute for Public Policy Research in Washington (as outlined in the New York Sun), is for the government to become investors in Fannie and Freddie, buying large amounts of senior subordinated debt.

The debt would pay a rate near the 10-year Treasury bond rate, and no dividends could be paid on the common stock of the enterprises as long as there were outstanding debt.

This approach would provide a return to taxpayers for backing the two enterprises while they got their houses in order for full privatization. There also would be changes in the capital requirements of the enterprises and in their governance.

Once the government debt was paid off, there would be no further government support for them, implied or explicit.

One thing is clear from the fiasco: Fannie and Freddie can’t continue to operate as they have — public companies can’t be protected from close oversight and challenges by friends in high places.