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  • Online Only: Repeating the mistakes of Fannie Mae, Freddie Mac

  • It is not only possible to replace Fannie Mae and Freddie Mac with a functioning private sector but essential to move the economy forward.

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  • It’s been more than 2-1/2 years since Fannie Mae and Freddie Mac were placed in government conservatorships, effectively making them wards of the U.S. Treasury. These two large “government-sponsored enterprises” (GSEs) are emblematic of the excesses of residential mortgage lending in the decade of the 2000s. The Treasury has already made $150 billion in capital contributions to keep them afloat, and there is at least another $50 billion — and possibly as much as $250 billion — still to come.
    Fannie and Freddie need to be put out of their (and the taxpayers’) misery.
    Unfortunately, a recent proposed bill by Rep. John Campbell, R-Calif., and Rep. Gary Peters, D-Mich., would replace them with five new private entities that, like the old Fannie and Freddie, would issue mortgage-backed securities (MBS) with explicit government guarantees.
    But lawmakers insist this time will be different. Why? Because these new firms will have to (i) hold more capital, (ii) be subject to strict underwriting standards, (iii) be regulated by an independent regulator and (iv) have to pay fees to the government for the MBS guarantee.
    Of course, all of this was already in place for Freddie and Fannie. They were subject to strict standards but through loopholes and government mandates took on greater mortgage risk; they were regulated by an independent regulator that wasn’t really qualified to deal with such a large systemic “banking’ institution; and they received fees for their guarantees though, as we know now, were set way too low. Why will it work any better this time?
    It may seem like a puzzle to many that a proposal like this could get traction. After all, both the administration and congressional leadership on this issue have called for a mostly private mortgage finance system with little or no government support.
    That said, neither side of the aisle is beating the drums with respect to a wholly private mortgage finance system. The concern is that, after years of being addicted to government support, going cold-turkey could get nasty. The analogy of what happens when someone tries to get off drugs — i.e., the “shakes” — applies to what might happen to the housing market when government support is taken away. Thus, the Campbell-Peters call for better-managed, GSE-lite entities. But it will inevitably lead to disaster because this bill provides no path towards true privatization, just more of the same government backstop, albeit in disguise.
    There is a better way. We have an innovative “side-by-side” transition plan for getting to a healthier mortgage finance system.
    Government MBS insurance should initially be available alongside the private-sector MBS guarantees. The initial fractions could be 75 percent government and 25 percent private. A crucial feature is that the price for the government guarantee would be identical to what the private partner charges — thus eliminating the possibility of underpriced and subsidized government insurance. This is very different from the Campbell-Peters bill or other proposals in which the government sets the pricing of mortgage default risk, and which will more likely be a back-door way to bring subsidy back into the broader mortgage market on a permanent basis.
    Page 2 of 2 - Because in our framework the guarantees are priced by the market, many investors will forgo the cost of this insurance and take on the risk themselves. The guarantees would also be available only where the underlying mortgages were high quality and below a specified dollar amount. Over time, as the private sector gained experience, the government percentage would be reduced, and the dollar amount ceiling would be reduced. By the end of, say, 10 years, government participation would be wholly phased out.
    Of course, the standard argument against this will surely be given: mortgage rates will go up. Yes, when a subsidy is removed, the cost does usually go up. But though we may eat chicken made of corn (or is it corn that is made to look like chicken?) because of agricultural subsidies, or drill for speckles of oil 5 miles deep in the ocean because of energy subsidies, or encourage homeowners to over-leverage themselves to buy bigger houses than they would have otherwise, we should not fool ourselves that this is good policy. These policies are a drag on economic growth and shift scarce resources away from more productive parts of the economy.
    It is not only possible to replace Fannie and Freddie with a functioning private sector but essential to move the economy forward. Surely the current crisis taught us that lesson. Do we really need to be struck by lightning twice?
    Viral V. Acharya, Matthew Richardson, Stijn Van Nieuweburgh and Lawrence J. White are professors at the NYU Stern School of Business and co-authors of the recently published book, “Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance.”

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