Mend, don't end, Fannie and Freddie.

AuthorMcLean, Bethany
PositionFederal National Mortgage Association and the Federal Home Loan Mortgage Association

CONSERVATIVES BLAME THE MORTGAGE GIANTS (WRONGLY) FOR THE FINANCIAL CRISIS, AND BOTH PARTIES WANT THEM EAD. But to finish the job of financial reform WITHOUT DESTROYING THE HOUSING MARKET AND COSTING TAXPAYERS BILLIONS, WE NEED TO LET THEM LIVE.

It's been almost a decade since the slow-rolling financial crisis, which reached its grand finale in the fall of 2008, got started. But as the response to The Big Short, the Academy Award-nominated film about the crisis based on Michael Lewis's book of the same name, shows, there's still a big fight about what actually went wrong. Some on the right wing immediately decried the movie, which focused on Wall Street's greed, for ignoring the problems with government policies encouraging homeownership--specifically, the role of the so-called government-sponsored enterprises (GSEs), the Federal National Mortgage Association and the Federal Home Loan Mortgage Association, better known as Fannie Mae and Freddie Mac.

While most Americans don't know what Fannie and Freddie do, many of us are in an intimate financial relationship with them involving the most important financial instrument in our lives--our mortgage--and the most important asset--our home. The way we finance housing, which makes up some 20 percent of the U.S. GDP, affects anyone who has a stake in our economy.

The idea that these little-understood but critically important companies caused the crisis is just the icing on top of the controversy about Fannie and Freddie, which were created by Congress to serve the dream of the United States as a society of individual homeowners. The two are essentially giant insurance companies. They stamp mortgages made to American homeowners with a guarantee that they'll pay the principal and interest if the homeowner can't. Their stamp makes it possible to package the mortgages backed by homeowners' monthly payments into securities, which are then sold to investors, who otherwise wouldn't want to bet their money that you and I will pay in full and on time. For years, although Fannie and Freddie had all the trappings of normal companies-- shareholders, boards of directors, stocks that traded on the New York Stock Exchange--they were also, in part, government agencies, with a congressional mandate to foster homeownership. Everyone always believed that if there were a crisis, the government would rescue them. Critics hated their government-granted political and financial power, their structure--wasn't it impossible for them to serve both shareholders and homeowners?--and the very idea that the government needed to be involved in the housing market.

Most people who weren't paying close attention probably date the beginning of the global financial crisis at September 15, 2008, the day Lehman Brothers declared bankruptcy. But a few days earlier, on September 6, the U.S. Treasury put Fannie Mae and Freddie Mac into a status called "conservatorship," a kind of government life support system hooked up because the rapidly swooning mortgage markets had put Fannie and Freddie in mortal peril, and their failure would have caused global economic chaos. The Treasury gave Fannie and Freddie an immediate $200 billion line of credit.

The conservatorship was orchestrated by Hank Paulson, then secretary of the treasury, who told President George W. Bush in a meeting at the Oval Office that it was, in essence, a "time out." According to the rhetoric in Washington at the time, that time out was supposed to end with the death of Fannie and Freddie and the creation of some better, less conflicted, more pure way of financing homeownership. "This is an opportunity to get rid of institutions that shouldn't exist," said Paul Volcker, the revered former chairman of the Federal Reserve, in 2011. Said President Barack Obama in 2013, "I believe that our housing system should operate where there's a limited government role, and private lending should be the backbone of the housing market."

And yet, here we are in 2016, and--surprise!--the companies are still very much with us. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was supposed to reshape the financial sector and which President Obama signed into law in the summer of 2010, quite deliberately did not deal with Fannie and Freddie. Nothing has happened since then, either. The GSEs remain wards of the government. As the longtime housing analyst Laurie Goodman wrote in a 2014 paper, "The current state of the GSEs can best be summed up in a single word: limbo." It turns out that solving the problem of Fannie and Freddie is the most difficult problem of the financial crisis.

Meanwhile, the mortgage market in the United States has effectively been nationalized, too. In fact, it is precisely the opposite of what President Obama said he wanted. According to Goodman, from 2008 to 2013 the government, mainly in the form of Fannie and Freddie, was the major source of credit for most people who got mortgages in the five years following the crisis. This trend hasn't changed. Goodman recently noted that the "private label" market-- mortgages packaged into securities by Wall Street, rather than by Fannie and Freddie--which hit $718 billion in 2007, plunged to $59 billion in 2008 and has not been above $64 billion since.

Nor have Fannie and Freddie shrunk. They still have some $5 trillion in securities outstanding. By one important measure, they are in more precarious shape than they were in the run-up to the crisis: thanks to a 2012 amendment to the terms governing their conservatorship, the government is taking almost every penny of profit that the two companies generate, so Fannie and Freddie have not been allowed to rebuild any capital, which could absorb losses in the event of another downturn in the housing market. "The two mortgage funders are effectively federal bureaucracies, stripped of their independence, with basically zero capital, but still dominating the market for mortgage financing," wrote the conservative pundits Alex Pollock and James Glassman in a recent Politico piece. "We are faced with running this business with really no cushion. It is a challenging situation for us," Fannie Mae CEO Timothy Mayopoulous said on a conference call in early 2015. "It's the last unsolved issue of the financial crisis, and the ramifications are enormous for everyone," says Ryan Israel, a partner at a hedge fund called Pershing Square.

Not only is the issue unresolved, signs of movement toward resolution are few. The omnibus spending bill President Obama signed in December contains a provision effectively preventing the administration from taking any action, and leaving it up to Congress. And the issue has barely been mentioned by any of the 2016 presidential candidates.

This broad silence reflects the genuinely thorny nature of the problem, but also the fact that virtually everyone in Washington supports "solutions" that are ideologically or politically convenient but don't make sense as policy. Tea Party Republicans favor killing off Fannie and Freddie and replacing them with nothing--a move that will, at best, hand the mortgage market over to the big banks and, at worst, crater the housing sector. The Obama administration and establishment types in both parties support eliminating Freddie and Fannie but replacing them with ... something else. Something perfect! Something that preserves all the benefits provided by Fannie and Freddie, but eliminates the old controversies and doesn't create new ones, and, oh, by the way, the money to fund this something will miraculously appear, and Fannie and Freddie's existing $5 trillion in liabilities will miraculously disappear, without any unpleasant ripples. A third option, which no one in Washington supports openly but all do operationally by their own inaction, is to keep Fannie and Freddie as they are: crippled government cash cows that will have to be bailed out (again) with the next (inevitable) cyclical decline in home prices.

There is, however, a fourth option: fix the flaws in Fannie and Freddie and let them operate, as they did-- effectively--for more than half a century, as the main public-private guarantors of the thirty-year mortgage. This idea might sound sensible to most Americans. But in Washington it is considered, if not completely insane, then at the very least a political nonstarter. Yet it does have some backers, including certain reform-minded financial analysts, think tank scholars, civil rights groups, lobbyists for small banks, and, curiously, a few hedge fund billionaires who bought Fannie and Freddie stock low and stand to make a killing if the companies are revived. While this odd assortment of players isn't getting much of a hearing right now, their idea has one advantage over all the others: it would actually work.

It's impossible to understand why Fannie and Freddie are such a difficult problem to solve without going back to long before the financial crisis--even before anyone had thought to invent mortgage-backed securities.

Homeownership is deeply ingrained in the American psyche, in part because our politicians have always stressed its importance. But for most of the early years of our history, the government wasn't involved. There were huge ups and downs in real estate, and great variability in the cost and the availability of credit. By the 1920s, mortgages were typically three to ten years in length, and required high down payments--sometimes as much as 50 percent. Homeowners often only paid off the interest, not the principal, so the mortgage had to be repaid or refinanced at maturity in one big "balloon" or "bullet" payment. If someone lived on the West Coast, they might pay double the rate of a person on the East Coast, where more lenders were based.

The Depression, which set off a vicious circle of plunging home prices and lack of access to credit, made a historically bad situation seem completely untenable. By the peak of the Depression, the national...

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