The Magazine

The End of Fannie and Freddie?

Closing the troubled housing agencies is not the only mortgage market fix we need.

Feb 28, 2011, Vol. 16, No. 23 • By ARNOLD KLING
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One of the recommendations of the report—to prevent Freddie Mac and Fannie Mae from holding mortgage securities in portfolio—has nothing to do with scaling back their role in mortgage lending. Instead, it bears the signature of lobbying by Wall Street, which wants to keep the lucrative business of mortgage securities trading all to itself. Say what you will about Freddie and Fannie, Wall Street’s designs on the mortgage market are even more rapacious, and its influence on policy potentially even more pernicious—especially if, as the report proposes, there is to be any sort of government “backstop” for the mortgage market.

This proposed backstop would simply be a new way of socializing risk, a Freddie Mac or Fannie Mae under a different name. The description of this backstop in the report is shockingly brief and sketchy. It appears, however, to be based on a paper entitled “The Economics of Housing Finance Reform: Privatizing, Regulating and Backstopping Mortgage Markets,” by David Scharfstein and Adi Sunderam, a professor and graduate student, respectively, at Harvard’s business school and economics department.

Even as described more fully in their paper, the backstop mechanism is not well thought through. The authors suggest setting up a nonprofit institution backed by the government that would operate in the mortgage insurance business.

The advantage of the nonprofit structure is that it presumably would not be motivated to expand. There is no guarantee, however, that what starts out as a nonprofit enterprise will always remain so. Freddie Mac was formed in 1970 as a government agency, but when the opportunity presented itself in the late 1980s, Freddie became a shareholder-owned corporation. Its executives were hardly passive bystanders in the transition process.

Scharfstein and Sunderam envision this backstop agency expanding during a crisis. However, the same goal could be achieved by injecting capital into mortgage insurance companies in such an event. Meanwhile, an inexperienced entrant into the mortgage insurance industry would expose taxpayers to significant losses from mistakes or misjudgment.

In addition to these proposals, the administration’s report contains a number of laudable features. For instance, it raises the issue of reining in the Federal Home Loan Banks, often-forgotten enterprises that pose significant risks to taxpayers. Like your appendix or your tonsils, the FHLBs are not needed in the body politic, but they could potentially cause considerable pain and discomfort if they are not removed in timely fashion.

Like the revolution in Egypt, the administration’s report begins a new era of promise and peril. Congress should set about to achieve the promise and avoid the peril.

Arnold Kling ia an adjunct scholar at the Cato Institute and member of the Mercatus Center at George Mason University.

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