The Zombification of Fannie and Freddie

Peter J. Wallison of the American Enteprise Institute has outlined several alternative futures for Fannie Mae and Freddie Mac, from nationalization to privatization. Unfortunately, the most likely outcome is that they will return as Government-Sponsored Enteprises and sow the seeds for yet another bailout in the future. Only privatization can stop the dead GSEs from returning as zombies.

By Robert Stowe England
February 18, 2010

In the current issue of Financial Services Outlook, Peter J. Wallison of the American Enteprise Institute lays out alternative future scenarios for Fannie Mae and Freddie Mac, both of which are currently under the conservatorship of the federal government.

The January-February 2010 issue of Financial Services Outlook, devoted entirely to Wallison's article, can be found at this link:

Wallison assesses the probability of each scenario and the likely outcome if that scenario is realized.


The first scenario is a complete government takeover, which would require that Fannie and Freddie's losses, which are likely to be at least $400 billion, be accounted for in the federal budget.

Fannie Mae was, in fact, converted into a Government-Sponsored Enterprise in 1970 in order to get its losses off the federal budget at the time of rising deficits. Enormous political pressure is likely to be brought to bear to prevent the nationalization of Fannie and Freddie, according to Wallison.

Public-Utility Structure

Under this approach Fannie and Freddie would be GSEs privately owned by banks or other private shareholders but would function like public utilities. Under this model, Wallison contends, the GSEs would no longer hold a portfolio of mortgages and mortgage-backed securities.

The borrowing would not be backed by the government. Wallison argues that mortgage securitization requres differential pricing to deal with differential risk among borrowers. Congress is likely to interfer in this pricing in such a way that higher quality mortgages will subsidize lower quality mortgages. This would make it easy for private sector competitors to undercut the higher GSE mortgage rates, which over time, would leave the GSEs with mortgages "skewed to the risky end of the curve," he writes.

Congress would likely confer some advantage to the GSEs to prevent this outcome, such as guaranteeing its mortgage-backed securities or giving it a monopoliy over a section of the market -- or both, Wallison claims. These guarantees would have to be scored in the budget and would amount to a high subsidy. Political forces are likely to suppress guarantee fees unduly. "With these fees too low for the risk involved, regulated utilities will eventually become insolvent," he contends.

Restoration as GSEs

Wallison explains why GSE's have always been so popular. "They appear to provide free money for purposes for which Congress would normally have to appropriate funds," he writes. GSE's can borrow with the implicit backing of the federal government and can be directed to spend their funds on policies and programs favored by Conbgress. Further, "GSEs can spend without the hassles of troublesome public reporting," Wallison notes.

The GSEs are likely to return to the practice of doing favors for important members of Congress while Congress pressure the regulator to weaken underwriting to service favored constituencies. Wallison points out that Rep. Barney Frank, Chairman of the House Financial Services Committee, has backed the elimination of Fannie and Freddie -- but not without Congress coming up with "a whole new system of housing finance." Wallison thinks the new system, not yet even on the horizon and likely years away from formation, will turn out to be the old system.

Wallison argues, then, that the "restoration of Fannie and Freddie as GSEs seems the most likely direction Congress will take once the housing-finance market stabilizes." It has in its favor the course of least resistance, while other alternatives are likely to be seen as "a leap into the unknown."

Congress is likely to argue that with better regulation under the Federal Housing Finance Administration, a future bailout will be prevented. That argument appears weak, as highly-regulated banks had to be bailed out .

The GSEs "are founded on a false premise: that private companies can perform a government mission," Wallison writes. "This cannot be true." The reason is that private companies must seek profit while a public mission requires devotion to that mission.

Wallison cites Professor Dwight Jaffee to back up his assertion that regulation is not enough; that in fact, "regulation needs the assistance of effective market discipline."

Wallison quotes Professor Jaffee as follows:

The flaw -- and I believe the fatal flaw -- with any and all plans to reconstitute the firms as GSEs is that they leave the inherent incompatibility of a private firm with a public mission. We have learned from first-hand experience that the incentive of a GSE with a government guarantee, implicit or explicit, is to expand its size and risk-taking as much as possible, and that these incentives ultimately dominate any public mission. I believe that the reestablishment of new GSEs will inevitably end with a new government bailout.

Citation: Dwight M. Jaffee, “The Future Role of Fannie Mae and Freddie Mac in the U.S. Mortgage Market” (paper presented at AEA/AREUEA session “The Future of the GSEs,” Atlanta, GA, January 3, 2010), 2, available at (accessed February 4, 2010).

Wallison argues that only privatization can avoid the moral hazards, failures and future bailouts for any institutions like Fannie and Freddie.

Wallison contends that the private sector was prevented from developing a prime mortgage securitization business because Fannie and Freddie drove out all the competition with their low-cost, government-backed competition. He suggests that once the securitization market has returned to normal, the government should privatize Fannie and Freddie while they are still in conservatorship.

In order to accomplish the privatization, Fannie and freddie will have to gradually sell of their $1.5 trillion in mortgages and mortgage-backed securities. This can be done over time, following the pattern of the sales of the savings and loans' assets accomplished by the Resolution Trust Corporation.

As for Fannie and Freddie's guarantees, Wallison recommends that they be handled through the process of defeasement. Defeasance is a technique by which a debtor unit removes liabilities from its balance sheet by pairing them with financial assets, the income and value of which are sufficient to ensure that all debt service payments are met.

As Treasury acknowledges losses that were guaranteed, it should "defease the continuing obligation on the GSE's guaranteesby placing them in a trust."Wallison states. Treasury will place risk-free Treasuries into the trust to cover potential losses.

Fannie and Freddie can then begin the process of allowing private sector competitors to take over the market by slowing reducing the conforming loan limit guarantee, currently at $730,000 for single hamily homes in expensive markets. As the limit moves toward zero, the private sector will gradually take over the entire market.

Wallison has done an excellent job of laying out the alternatives and the potential outcomes for each choice. Perhaps a new Congress next year, elected to bring Washington spending under control, will be in more of a mood to face honestly the task of winding down Fannie and Freddie to prevent their resurrection as permanent zombies kept afloat by taxpayers in perpetuity.

Given the spectacular failure of Fannie and Freddie as GSE's, surely champions of privatization can emerge in Congress to pursue the right course.

© 2010 Robert Stowe England. All Rights Reserved.


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