Explaining FinReg: Fannie and Freddie
The right way to think about Fannie Mae and Freddie Mac is to think about the widespread availability -- at least before the crisis -- of 30-year, fixed-rate mortgages with no prepayment penalty. That is not a financial product that flourishes in the state of nature, and for obvious reasons. If you're a bank, why do you want those mortgages? If interest rates go down, people refinance and pay the loan back early. If they go up, you might be losing money on the loan. It's heads they win, tails you lose.
If you've got one of those mortgages, though, you might have Fannie Mae and Freddie Mac to thank. The mortgage giants, slightly confusingly, do not sell mortgages. They buy them from the banks that sell them. About 90 percent of them, to be precise. They do that to make mortgages -- and thus home ownership -- cheaper. That's fine. If the country wants to encourage home ownership as a policy, subsidizing banks so they can offer better mortgage terms is a sensible way to do it.
The problem is that Fannie and Freddie are not a direct and simple subsidy for the banks. They are private companies with a government charter. Rather than using taxpayer dollars to subsidize mortgages, they were borrowing money very cheaply because their quasi-governmental status assured the market that there'd be a taxpayer bailout in the case of any sort of collapse. That is to say, their business model relied on markets ignoring the risk of their activities. And then, because they were private companies with shareholders to please, they also got into slicing and dicing mortgage packages to make money like an investment bank rather than a housing policy. In theory this should've worried the markets where they borrowed their money, but again, the government backstop saved them. Forget too-big-to-fail. This was not-allowed-to-fail.
So, of course, they failed. As Raj Date of the Cambridge Winter Center put it to me, "anytime the debt markets aren't paying attention to your risk profile, you're doomed."
Their failure was not, as some would have it, the cause of the mortgage crisis, or even close. For one thing, only about 2 percent of their portfolio was subprime. For another, they didn't start backstopping the subprime market till long after it had taken off. And for a third, their greatest losses actually were in non-subprime loans.
But they were part of the problem. And the fundamental mismatch between their risk and activities will continue to cause problems. But solving the Fannie and Freddie problem is more complicated than it might appear. What you're talking about, essentially, is a massive subsidy for home ownership. That is to say, a massive subsidy for the middle class. So easy as it is to talk about the failure of Fannie and Freddie, it's a lot harder to talk about their elimination, as that's talking about the removal of a popular subsidy in a fragile market.
Which explains why the Republican financial-regulation proposal handled the Fannie and Freddie problem by directing the president "to submit a plan to reform [Fannie and Freddie] to Congress no later than six months after the enactment of the Act." Republicans don't normally solve problems by asking President Obama to solve them, but no one wants their fingerprints on this one.
Of course, you don't necessarily need to eliminate Fannie and Freddie. You could solve the problem by fully incorporating them into the government and making them a straightforward housing subsidy rather than a stealth housing subsidy hidden within a profit-maximizing company. But it's not clear that bringing more major institutions under the control of the government is going to be popular, either. So what do you do?
Well, it's hard to say. Procedurally, Democrats think that the Fannie and Freddie question is a housing market question and should be dealt with in the context of a major housing-policy bill. What that bill will do, however, is anyone's guess. And that's pretty much where we are on Fannie and Freddie.
Want to go deeper? This paper (pdf) by Date is a good place to start.
Posted by: Hopeful9 | May 5, 2010 6:13 PM | Report abuse
Posted by: stantheman21 | May 5, 2010 7:52 PM | Report abuse
Posted by: stantheman21 | May 5, 2010 8:13 PM | Report abuse
Posted by: jamessilver | May 5, 2010 8:58 PM | Report abuse
Posted by: BillEPilgrim | May 6, 2010 5:39 AM | Report abuse
Posted by: MosBen | May 6, 2010 7:27 AM | Report abuse
Posted by: staticvars | May 6, 2010 10:18 AM | Report abuse
Posted by: Buzz11 | May 6, 2010 12:33 PM | Report abuse
Posted by: INTJ | May 6, 2010 1:28 PM | Report abuse
The comments to this entry are closed.