Fannie and Freddie’s Confused Futures

(cross-posted with Benzinga.com)

A few days after the Obama administration released its vague concepts for the future of Fannie and Freddie it issued budget estimates for Fannie and Freddie’s losses premised on the continued existence, indeed, expansion of Fannie and Freddie. The administration assumed that the cost of resolving Fannie and Freddie would drop by roughly one-half – by 2021. The predicted reduction in losses appears to come not from improvement in Fannie and Freddie’s bad assets, but rather from profits on Fannie and Freddie’s overall operations. These profits stem from Fannie and Freddie, which are now publicly-owned, being able to borrow funds at or near the governmental rate. That price advantage makes it impossible for any private entity to compete with them in the secondary market. This purported reduction in the cost to the public of resolving Fannie and Freddie’s failures is not really an economic savings – unless one ignores the implicit cost of issuing government debt to fund Fannie and Freddie. The nominal accounting savings, however, will be exceptionally attractive to politicians. Administration officials will have an overpowering desire to claim that their brilliance cut Fannie and Freddie’s costs in half. Collectively, this will provide powerful incentives to continue Fannie and Freddie as a huge governmental enterprise.

We need to understand why Fannie and Freddie became massively insolvent. It wasn’t because they were governmental, but because they were private. It is simple to run Fannie and Freddie in a safe and sound fashion. Fannie created the concept of prime loans and prime loans have exceptionally low credit risk. Fannie and Freddie can easily spot any degradation in credit quality by reviewing samples of the loans insisting on full underwriting. Fannie and Freddie can minimize interest rate risk by creating and selling MBS and hedging the pipeline risk. When Fannie and Freddie were governmental 25 years ago they did not deliberately take excessive risks. They did not understand how to hedge in a fully effective fashion, but we have learned a great deal in 25 years about how to hedge pipeline risk.

The risks to Fannie and Freddie are governmental, not financial. The government could decide to do extremely destructive things to Fannie and Freddie.

The risks to a privatized Fannie and Freddie (by whatever name) are even greater. If the existing systemically dangerous institutions (SDIs) became private label securitizers they would have all the perverse risks that come from modern executive compensation. They would pose a systemic risk if they were to fail – which is why regardless of how much the government promised not to bail them out no one would believe it. That is why they would be GSEs regardless of their official designation. The more they are perceived as GSEs the greater the political risk that Congress will demand dangerous actions from the private label securitizers.

It is not clear why the administration believes that securitization of mortgages is necessary or even desirable. Portfolio home lenders will face prepayment and interest rate risk, but those risks are simply transferred, not removed, by securitization. Given what we have learned from the crisis, the assumption that securitization leads to an efficient distribution appears baseless. Some banks will doubtless fail if interest rates increase sharply and remain high for many months, but hedging and macroeconomic policy can greatly reduce the failure rate among banks.

The first step, however, should be to make the existing disaster that is Fannie and Freddie fully transparent. We need to investigate fully what went wrong. If Fannie and Freddie put all their information on the web we could bring the wisdom of the masses to bear and determine the truth. There is no reason why Fannie and Freddie should have broad proprietary secrets.