Treasury’s plan for releasing Fannie Mae and Freddie Mac from their conservatorships is missing only one thing: a good reason for doing it. The dangers the two companies will create for the U.S. economy will far outweigh whatever benefits Treasury sees.
Under the plan, Fannie and Freddie will be fully recapitalized — probably by allowing them to keep all or a portion of their profits and by selling shares to the public. However they are recapitalized, Treasury makes clear that they will continue to be backed by the government — a benefit for which they will be required to pay.
The Treasury says the purpose of their recapitalization is to protect the taxpayers in the event that the two firms fail again. But that makes little sense. The taxpayers would not have to be protected if the companies were adequately capitalized and operated without government backing.
Indeed, it should have been clear by now that government backing for private profit-seeking firms is a clear and present danger to the stability of the U.S. financial system. Government support enables companies to raise virtually unlimited debt while taking financial risks that the market would routinely deny to firms that operate without it.
Nor, it seems, has Treasury considered what kind of business Fannie and Freddie will likely pursue as government-backed profit-seeking firms.
When Fannie and Freddie had minimal capitalization and a free but “implicit” government guarantee, profitability was easy. Most of the housing finance market was open to them, and they could set their pricing at levels others could not match. That enabled them to drive competitors out of any portion of the market that they wanted to dominate. By the early 2000s they were acquiring and securitizing — or holding in portfolio — about 50 percent of all U.S. mortgages.
They will not be able to do this under Treasury’s plan. The demands for profitability from their shareholders, coupled with the cost of their government backing, is almost certain to eliminate the pricing advantages that allowed them to dominate the housing finance market before the financial crisis.
Still, their government support will allow them to earn significant profits in a different way — by taking on the risks of subprime and other high-cost mortgage loans. That business would make effective use of their government backing and — at least for a while — earn the profits that their shareholders will demand.
The Treasury plan warns Fannie and Freddie that they will have to earn “less than the return on other activities” when they acquire the mortgages of “low-and-moderate-income families.” But this only means that they will have to earn more on the middle-class mortgages that are the heart of the housing finance market.
This is an open invitation to create another financial crisis. If we learned anything from the 2008 mortgage market collapse, it is that once a government-backed entity begins to accept mortgages with low down payments and high debt-to-income ratios, the entire market begins to shift in that direction.
Middle-class homebuyers, who could otherwise afford the down payments and other terms of a prime mortgage, seek out the opportunity to buy a larger home with a low or no downpayment.
Only a firm with government backing could pursue this business, but it will be a plausible profit-making activity for Fannie and Freddie once they are released from the conservatorships and free to exploit their government guarantee. In the midst of the housing boom in the early 2000s, Fannie’s staff noted that 37 percent of the subprime mortgages they were acquiring — ostensibly to meet the government’s affordable-housing goals — were going to homebuyers above median income.
The results were clearly on view in 2008, when a collapse in the home-mortgage system brought on by the prevalence of weak and risky mortgages produced a monumental financial crisis. Fool me once, shame on you; fool me twice, shame on me.
Given this potential outcome, why is the Treasury proposing this plan? There is no obvious need for a government-backed profit-making firm in today’s housing finance market. FHA could assume the important role of helping low- and moderate-income families buy their first home.
We would all be better off if the Federal Housing Finance Agency — the GSEs’ regulator and conservator — simply decided to withdraw them gradually from the market. As their conservator, FHFA has the power to do this by reducing the size of the mortgages they are permitted to buy until they are no longer significant players in housing finance. Banks and private securitizers would then easily take their place, most likely focusing solely on prime mortgages.
In that case, of course, today’s speculators in Fannie and Freddie stock would be the losers, but the taxpayers and the financial markets would be saved from a major future loss.
Why this hasn’t already happened in a conservative administration remains an enduring mystery.