Long-Term Solution for Fannie and Freddie Dilemma

It’s been a rough year for Fannie Mae and Freddie Mac. Share values have dropped more 90 percent, investors have lost more than $100 billion, and both companies were rescued by the federal government earlier this month, placed in a government conservatorship run by the newly created Federal Housing Finance Agency.

But a long-term role for Fannie and Freddie needs to be considered as well.

First, Fannie Mae and Freddie Mac are not just lumbering financial giants that can be easily replaced. They are the largest buyers of U.S. home mortgages. There is no competitor or group of competitors that can take over what they do in the short term, say a year or two, or maybe ever. If Fannie Mae and Freddie Mac collapse the result would be the wholesale destruction of the national mortgage system; a virtual halt to home sales because few local mortgages would be available; soaring interest rates because few loans would be available and a level of losses throughout the economy unseen since the Great Depression.

Second, some people think it would be a really good idea to dismember Fannie Mae and Freddie Mac.

“I say that we can’t let them go fast enough,” explains a commenter by the name of Wazzel who posted on the Washington Independent website. “Let them go. Let them all go. NOTHING will be resolved until the things that ought to fail…fail! Propping-up this nonsense with money borrowed from China does nothing to fix the problem at hand. Housing prices must fall to get the national average from 200K down below from 70K to reset the housing market and get equities back in line with reality.”

What is it that has so many people mad with Fannie Mae and Freddie Mac?

In many cases it’s not profits, losses, share values or loan policies, it’s merely that Fannie Mae and Freddie Mac exist.

Fannie Mae and Freddie Mac are positioned at an odd intersection of commerce and government. They are profit-seeking “companies” in the sense of shareholders and being in business but they are also GSEs — government-sponsored enterprises, companies started by the federal government and companies endowed with huge competitive advantages: They do not pay state income taxes, they each have a $2.25 billion direct line of credit with the U.S. Treasury in case of emergency and for decades they did not have to maintain the bookkeeping standards required by the Securities and Exchange Commission.

Several years ago the comfy niche enjoyed by the big GSEs began to unravel. Under enormous political pressure, both Fannie Mae and Freddie Mac allowed that they would agree on a “voluntary” basis to abide by SEC accounting standards.

Fairly soon it became apparent that the joyous financial statements issued by both companies were as real as vampires and unicorns. In basic terms, the numbers had been tilted to assure big benefits for company executives. At Fannie Mae, as one example, the company incentive plan paid 749 employees an average bonus of $86,952.56 in 2003. Restatements, massive fines and big accounting costs followed the accounting revelations.

The huge problems at Fannie Mae and Freddie Mac were supposed to be resolved with new management and revamped accounting, but no resolution could revolve a basic issue: Private mortgage buyers are always at a disadvantage when competing against Fannie Mae and Freddie Mac.

Not only must private competitors pay state income taxes and other costs, the GSEs have been able to get investor capital at low cost because of the perception that the federal government would not let either company fail. If you believe in free markets and fair competition, the GSEs are a poke in the eye.

“As long as Fannie and Freddie’s debt is backed by the full faith and credit of the U.S. government, Fannie and Freddie don’t need to be solvent,” says the Wall Street Journal. “They can continue to function. The world’s lenders will continue to lend to them. At this week’s refunding, Freddie paid less for its money than a blue chip like IBM or GE would pay, even as Freddie’s share price verged on penny-stock territory.”

What happened over the summer was a plain and overt effort to nationalize the GSEs under the cloak of the mortgage worries, and the mere threat of nationalization had consequences. Why would anyone invest in either company if they’re instant candidates for a federal take-over? Nationalization would drive share values down to zero. Alternatively, if they cannot raise additional capital then the case for GSE nationalization becomes stronger and the shares held in-house by each company have less worth. In effect, the threat of a federal take-over discourages the very financing that could make both companies more economically secure.

There is, however, an alternative to nationalization — one suggested in a column I wrote in 2004. Back then I said “the time has come for Fannie Mae and Freddie Mac to end their quasi-government status and join the rest of the risk-taking and tax-paying mortgage buyers who populate the private sector.

“However, the march to privatization should not be instant or foolish. We can use a phased approach to re-assure both the public and investors that life will go on even if Fannie Mae and Freddie Mac must compete on equal terms in the mortgage marketplace. For instance, we might create a three-year transition schedule. In year one the GSEs would lose one-third of their ability to avoid state taxes. In year two they would lose two-thirds. In year three all state taxes would be due and payable. The same principle, of course, can apply to other special benefits now reserved for GSEs.”

While nationalization will harm innocent Fannie Mae and Freddie shareholders, privatization would force the GSEs to act competitively, just like any company. Rather than fail, they would enter the private sector with huge advantages because of their enormous size, vast holdings and institutional heritage.

The benefit of privatization would go far beyond Fannie Mae and Freddie Mac. Billions of dollars in subordinated debt from both companies is used by banks nationwide as part of their capital base. If the two GSEs are further harmed, the banking system itself will face additional financial threats.

“The potential effects of a rescue become more complex for the holders of Fannie’s and Freddie’s $19 billion in subordinated debt, so-called because it ranks below other bonds in the companies’ capital structures,” says The New York Times. “As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.”

Could the nation’s banking system stand the loss of $19 billion? As the old expression goes, it wouldn’t help.

Commercial banks and savings institutions insured reported a net income of $5 billion in the second quarter of 2008, according to the Federal Deposit Insurance Corporation (FDIC). That’s a drop of 86.5 percent from the $36.8 billion that the industry earned in the second quarter of 2007. With the exception of the fourth quarter of last year, the latest earnings were the lowest for the industry since the fourth quarter of 1991.

With gradual privatization, the speedy move toward nationalization seen during the past few weeks would no longer be a threat to the financial security of either Fannie Mae or Freddie Mac. Company stock would rise and with it the security of bond holders and shareholders alike. That would be good for the GSEs — and good for the national banking system.
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Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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