Nightmare on Every Street

How to carve Fannie and Freddie into pieces

Fannie Mae and Freddie Mac are broke. The two government-sponsored enterprises (GSEs) that togetherfinance more than $5 trillion in mortgages are insolvent, if you don’t count the $150 billion alr

eady injected into them by the federal government. The common shares of these state-corporate hybrids have lost more than 99 percent of their value, both have been delisted from the New York Stock Exchange, and since September 2008 they have been official wards of the

 state. The largest owner of their obligations is now the United States Federal Reserve.

Housing finance inflation was at the center of the financial crisis, and the GSEs were at the center of housing finance inflation. Any meaningful reform of the mortgage system, and therefore the financial problems underlying the recession, must deal directly with Fannie and Freddie. But last summer our elected representatives instead passed a 2,300-page financial “reform” act that purposefully avoided addressing this central issue.

Discussions of how to reform Fannie and Freddie have now belatedly begun on Capitol Hill and in the Obama administration. The process will be complicated and controversial. But if we are to avoid future distortions and
government-inflated bubbles in the housing market, Fannie and Freddie can and should be dismantled.

Divided and Conquered

The core problem with GSEs isn’t hard to understand. You can be a private company disciplined by the market, or you can be a government entity disciplined by the government. If you try to be both, you can avoid both disciplines.

To fix that, the first step is to put the GSEs into receivership (as opposed to the current conservatorship), so that the small remaining value of the common shares and all their governance rights are wiped out. Then the restructuring can proceed, Julius Caesar style: divide them into three parts.

The first of those parts, unfortunately, must be a “bad bank,” a liquidating trust that will bear Fannie and Freddie’s deadweight losses—the $150 billion spent by the Treasury so far, plus the additional losses that are embedded in the GSEs’ portfolios and will be realized over time. According to various estimates by the CBO and private analysts, it will cost in the range of $200 billion to $400 billion to make whole the foreign and domestic creditors of Fannie and Freddie. That cost will unjustly, but at this point unavoidably, be borne by taxpayers.

All the current debt and mortgage-based securities obligations that bear the Treasury’s implicit but very real guarantee should be placed in these trusts to run off over time, with all the current mortgage assets of the GSEs dedicated to servicing them. These trusts will be responsible for liquidating the old GSEs. They can be modeled on the structure used in the 1996 act that privatized another GSE: Sallie Mae, the federal student loan company.

The second of the three parts should be formed by privatizing Fannie and Freddie’s prime mortgage loan securitization and investing businesses. All their intellectual property, systems, human capital, and business relationships should be put into truly private companies, sold to private investors, and sent out into the world to compete, flourish, or fail like anybody else. As fully private enterprises, they will be free to do anything they think will create a successful business—except trade on the taxpayers’ credit card.

When there is a robust private secondary market for the largest segment of Fannie and Freddie’s business—high-quality prime mortgage loans to the middle and upper middle classes—private investors can then put private capital at risk, taking their own losses and reaping their own gains. In this mortgage sector, the risks are manageable, and no taxpayer subsidies or taxpayer risk exposures are necessary. 

Decades ago, there may have been an argument for GSEs to guarantee the credit risk of prime mortgage loans in order to overcome the geographic barriers to mortgage funding, barriers that were themselves largely created by government regulation. More recently, there may have been a case for using GSEs to get through the financial crisis that they themselves had done so much to exacerbate. But as we move into the future mortgage finance system, the prime mortgage market can and should stand on its own, just like the corporate bond market.

A private secondary market for prime mortgages should have developed naturally a long time ago. It didn’t because no private entity could compete with the GSEs’ government-granted advantages. Bond salesmen, pushing trillions of dollars of GSE debt and mortgage-backed securities to investors all over the world, basically told them this: “You can’t go wrong buying this bond, because it is really a U.S. government credit, but it pays you a higher yield. So you get more profit with no credit risk.” Although there was, and still is, no formal government guarantee of Fannie and Freddie’s obligations, what the bond salesmen told the investors was nonetheless true, as events have fully confirmed. The Treasury has made it clear that its financial support of Fannie and Freddie is unlimited.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

  • Jordan||

    Carve them? Uh no. Burn them to the ground and salt the fucking earth.

  • ||

    Someone needs a manicure. And a facelift.

  • Freddie Kruegman||

    Just have the Federal Reserve "buy up the debt."

    BWAHAHAHAAA!

  • Dick Cheney||

    why don't we just print more money?

  • tr0n||

    Author probably have looked at the Wikipedia page for deadweight loss before trying to use it in a sentence.

  • tr0n||

    SHOULD HAVE! D'oh

  • Pip||

    "What I wouldn't give to be able to wipe my own ass."

  • worth a try||

    http://www.truthdig.com/report....._20101006/

    Good ol' Austie bashing... check comments below article.

  • Some Guy||

    The third part to be carved from Fannie and Freddie should consist of intrinsically governmental activities, such as housing subsidies and nonmarket financing of risky loans. These should move explicitly to the government, where they will be fully subject to the discipline of congressional approval and appropriation of funds.

    Wait...WHAT?

  • ||

    I get what you're saying. But as long as federal government is going to do things like provide housing subsidies, etc - which it unfortunately will - the appropriations must follow the same rules as any other program.

    Fannie and Freddie have played both sides against the middle for years.

  • Ayn_Randian||

    Some Guy - better than a total lack of accountability.

  • ||

    I'm prepared to bet dollars to donuts (okay, not as good odds as it used to be) that, as useful as these suggestions are, there will be no substantive changes in Fannie or Freddie. Hell, with the proposed "infrastructure bank" the administration is already trying to expand upon the GSE model. Fannie and Freddie have proven a wonderful sinecure to enrich (predominantly Democratic) political allies. Hell, the new National Security Advisor was Fannie's EVP for Law and Policy. You'll take the gravy train away from these guys when you pry it from their cold dead hands.

  • ||

    let them go under, no more fed money.

  • ||

    It would be very nice, as well, if in the process of tearing down all these GSE's that the Congresscritters figured out a way for the rent-seeking parasites who benefited from them don't get to benefit from the re-structuring. Completely elminate them, put them all into genuine bankruptcy, and let them and their buddies eat the loss without any more taxpayer money.

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