Politics & Policy

Housing Reforms Built on Sand

A fortnight of political theater ended with a back-to-reality splash of cold water on Sunday when Treasury Secretary Hank Paulson announced a government takeover of Fannie Mae and Freddie Mac. Fannie and Freddie do not have enough capital to convince investors that they can pay their debts. If enough investors lose confidence and stop lending to the mortgage giants, they could collapse, with catastrophic consequences for the international financial system.

To prevent this, Paulson announced that the U.S. government will place the companies into conservatorship and shore them up with an investment of billions of taxpayer dollars. Under this plan, a new federal housing regulator will take over Fannie and Freddie, replacing their boards and managers. In addition, Paulson announced that the Treasury Department will recapitalize the companies by investing billions in a super-preferred class of stock.

The plan is designed to help Fannie and Freddie ride out the current wave of falling housing prices and to preserve the companies in something like their current form. This is a necessary intervention, but it does not go far enough. Paulson’s actions fail to resolve the fundamental problem that got us into this mess. As long as Fannie and Freddie exist as public/private hybrid enterprises, investors in the companies will reap the rewards when they succeed and taxpayers will cover the costs when they fail. This structure, a classic moral hazard, encourages heedless growth and excessive risk-taking, and it is the reason Fannie and Freddie hover on the brink of insolvency now.

Paulson said as much in his statement announcing the plan. He called Fannie and Freddie’s business model “flawed” due to the “inherent conflict” between their public and private missions. He said, “it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.”

But Paulson’s solution — a conservatorship — would preserve the companies in their current form, which is exactly the wrong approach. Under Paulson’s plan, shareholders lose some value, but they are not wiped out entirely. Their rights are merely suspended, and one can foresee the day — after Fannie and Freddie are returned to sounder footing — that the shareholders regain a say in how the companies are run. At that point, it’s back to the bad old days of private profits and public risk.

Policymakers can avoid this problem by placing Fannie and Freddie into receivership instead. In a receivership, shareholders’ rights are terminated. In Fannie and Freddie’s case, a federal receiver would take over the companies and draw upon a line of credit at the Treasury Department to pay down the companies’ debt while continuing to provide liquidity to the housing market.

More important, a receiver for Fannie and Freddie could move the companies toward full privatization. For decades, the companies’ government sponsorship and implicit taxpayer backing have allowed them to dominate the secondary mortgage market, where the lack of competition impeded innovation. Backed by the government and enjoying easy access to cheap credit, the companies engaged in excessive risk-taking and grew too large to fail. A federal receiver would have the power to shrink the companies and to reconstitute them as private, state-chartered enterprises.

In explaining why he did not take bolder action, Paulson said, “Because [Fannie and Freddie] are congressionally chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission.” But this is a dodge. Congress has already spoken on this issue. One of the few redeeming aspects of the housing bill that became law this summer is that it created a new regulator that has the power to put Fannie and Freddie into receivership if they become “critically undercapitalized.”

That new regulator, the Federal Housing Finance Agency (FHFA), has indeed determined that Fannie and Freddie are not adequately capitalized, but Paulson and FHFA director James Lockhart have opted for conservatorship instead of receivership. Two reasons could explain why they chose to play it safe. First, by offering to suspend rather than terminate shareholders’ rights, Paulson and Lockhart were able to get Fannie and Freddie’s boards and managers to “go quietly,” as they say. Second, Fannie and Freddie have powerful allies on Capitol Hill (a result of decades of intense lobbying), and these lawmakers want the companies’ status as government-sponsored enterprises to be preserved.

But Paulson and Lockhart have an obligation to do better. They are about to put billions of taxpayer dollars on the line in what is potentially the biggest bailout in U.S. history. If they preserve Fannie and Freddie’s flawed business model, they guarantee that the next bailout will be even bigger. The only foundation for real reform is one that puts these enterprises on the road to full privatization and frees the mortgage market from domination by these bloated behemoths.


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