The Tea Party Is Right About Fannie and Freddie

No, the mortgage giants weren’t the only reason for the crisis, but their loan guarantees create a moral-hazard problem that encourages risk-taking.

WASHINGTON, DC - NOVEMBER 09: Fannie Mae's headquarters in the nation's capital are seen November 9, 2011 in Washington, DC. Citing the rise in defaults on loans it has guranteed, the government-controlled mortgage giant is asking the federal government for $7.8 billion in aid to covers its losses in the in the third quarter of FY 2011. Fannie has received $112.6 billion so far from the Treasury Department - the most expensive bailout of a single company. 
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Matthew Cooper
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Matthew Cooper
Nov. 7, 2013, 4 p.m.

It’s been five years since Fan­nie Mae and Fred­die Mac went un­der dur­ing the fin­an­cial crisis. Since then, the mort­gage gi­ants have been in con­ser­vat­or­ship. Con­gress is still pon­der­ing what to do. Every­one’s pretty much agreed that the two should go. (For the re­cord, neither lends money to homeown­ers dir­ectly; they buy mort­gages and turn them in­to fin­an­cial in­stru­ments that can be traded — thus pump­ing more money in­to the hous­ing-fin­ance mar­ket.) The ques­tion is, what should re­place Fan­nie and Fred­die? And it’s there that the House con­ser­vat­ives ad­mired by the tea party have offered an in­triguing solu­tion, al­beit one that’s gal­van­ized many oth­er Re­pub­lic­ans and busi­ness in­terests in op­pos­i­tion.

The plan, pro­posed back in 2011 by Jeb Hensarling, the chair­man of the House Fin­an­cial Ser­vices Com­mit­tee, would ab­ol­ish Fred­die and Fan­nie; but the big thing his pro­pos­al would do is elim­in­ate any guar­an­tee that the gov­ern­ment would bail out a new en­tity. The bill would cre­ate a plat­form for in­vestors to se­cur­it­ize mort­gages — kind of like the old Fan­nie — but there’d be no fall­back res­cue plan. Hensarling says this would end “the boom, bust, and bail­out cycle,” be­cause in­vestors would take few­er chances with their money; that cau­tion would re­move the fuel that triggered the flood of hous­ing fin­ance that, in turn, en­cour­aged people to glee­fully buy what they couldn’t af­ford — cre­at­ing the price bubbles and de­faults that led to the fin­an­cial crisis. What’s more, Hensarling’s plan would rule out a huge price tag like the $180 bil­lion to bail out Fred­die and Fan­nie.

Over in the Sen­ate, Mark Warner and Bob Cork­er see it dif­fer­ently. The Vir­gin­ia Demo­crat and the Ten­ness­ee Re­pub­lic­an are known for seek­ing com­mon ground in a di­vided cham­ber. To­geth­er, they have been work­ing for more than a year on their own plan for ab­ol­ish­ing Fan­nie and Fred­die and re­pla­cing the two en­tit­ies with a mort­gage mar­ket that re­quires large amounts of private cap­it­al to ob­tain a gov­ern­ment guar­an­tee. In oth­er words, the in­dustry would be put­ting up its own kind of in­sur­ance in case things go wrong, akin to the way plain-old banks pony up in­sur­ance money to pro­tect cus­tom­ers’ de­pos­its. But if a cata­stroph­ic eco­nom­ic event oc­curs, the gov­ern­ment then would provide a guar­an­tee for in­vestors. The pres­id­ent has praised the Cork­er-Warner ap­proach, and his ad­min­is­tra­tion had provided con­sid­er­able tech­nic­al as­sist­ance. “We’ve been on the phone with them a lot,” Cork­er says.

Both sen­at­ors say the guar­an­tee is es­sen­tial to pre­serving the 30-year mort­gage. Without a gov­ern­ment back­stop, they ar­gue, in­vestors will not fin­ance a risky en­deavor such as the stand­ard mort­gage loan — which may ap­pear vanilla to homeown­ers but to in­vestors rep­res­ents con­sid­er­able risk be­cause in­terest rates fluc­tu­ate wildly over the gen­er­a­tion-long term of the loan. “If you don’t have this [guar­an­tee],” Warner says, “there would be dra­mat­ic­ally high­er in­terest rates, no 30-year mort­gage, and you would see a dra­mat­ic­ally dif­fer­ent hous­ing mar­ket.”

The myri­ad groups in­volved in hous­ing over­whelm­ingly back the idea of keep­ing a guar­an­tee. “We’re act­ively and ag­gress­ively op­pos­ing [the House bill],” says Jam­ie Gregory of the Na­tion­al As­so­ci­ation of Re­altors. The hous­ing phalanx in Wash­ing­ton is a for­mid­able one, in­volving lob­bies from fin­an­cial in­sti­tu­tions to build­ers to com­munity act­iv­ists who want more af­ford­able hous­ing. “Every­body in the in­dustry be­lieves that [Fan­nie and Fred­die] re­form needs to take place … but the com­plete elim­in­a­tion of the gov­ern­ment guar­an­tee is not vi­able,” says Dav­id Stevens, pres­id­ent and CEO of the Mort­gage Bankers As­so­ci­ation.

While those con­cerns are le­git­im­ate, elim­in­at­ing the gov­ern­ment back­stop may be less risky than it seems. Here’s the case for get­ting rid of the guar­an­tee. The first reas­on is that it cre­ated a mor­al haz­ard, en­cour­aging in­vestors in mort­gage-backed products to be reck­less, be­cause they knew they could be bailed out. That ir­re­spons­ible spend­ing on the hous­ing side made it ri­dicu­lously easy to get a loan, thereby send­ing de­mand and prices up, cre­at­ing the famed bubble. It’s a stretch to say Fan­nie Mae alone caused the fin­an­cial crisis; many oth­er act­ors played a part. But there’s no ques­tion that the guar­an­tees are a big prob­lem, and it’s fair to ask if the more sens­ible guar­an­tees in Cork­er-Warner would still en­cour­age bubbles.

There’s an­oth­er reas­on for get­ting rid of the guar­an­tee: evid­ence of enough money float­ing around the sys­tem to keep the 30-year mort­gage alive and well, des­pite the hous­ing lobby’s fears. Look at the mar­ket for “jumbo” mort­gages, those loans too large to have had a guar­an­tee un­der Fan­nie. They have his­tor­ic­ally done well. Who’s to say fund­ing can’t be found for less valu­able 30-year mort­gages? “From what I know about cap­it­al­ism,” Hensarling says, “if some­body de­mands a product, they’ll get it.” Those in the Hous­ing In­dus­tri­al Com­plex want the guar­an­tee, des­pite its prob­lems in the past, be­cause they fear what would hap­pen to in­terest rates and avail­ab­il­ity of cap­it­al. Fair enough. If the crit­ics are right and the money does dry up for the hous­ing mar­ket, Con­gress can al­ways turn back to some kind of guar­an­tee. But first, let’s see if the mar­ket works.

Warner and Cork­er would like to get their bill mov­ing to the Sen­ate floor this year. “I am ac­tu­ally op­tim­ist­ic,” Warner says. And, in­deed, his bill has bi­par­tis­an co­spon­sors and is likely to be­come the basis for a Sen­ate Bank­ing Com­mit­tee bill. For his part, Hensarling will have to sell the idea to a House Re­pub­lic­an Con­fer­ence that will be un­der pres­sure to block it un­less he backs down on guar­an­tees. That would be an un­for­tu­nate re­treat. The guar­an­tees didn’t cause the fin­an­cial crisis, but they made it worse. In­dustry and the mar­kets cling to them. And that may be ex­actly the reas­on to be done with them.

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