The Future of Fannie and Freddie

by DEAN BAKER

President Obama’s announcement of his plans for a restructured mortgage market was painful for those who remember the bubble and crash. It seems as though he learned nothing from this disaster.

The key problem in the bubble years was the ability of private actors to profit by taking huge risks in issuing and securitizing bad mortgages, while handing the downside risk to taxpayers. This was the story with Countrywide, Bank of America, Goldman Sachs, Citigroup and the rest.

It was also the story with Fannie Mae and Freddie Mac in their prior incarnation, before the collapse of the bubble sent them into conservatorship. The pre-conservatorship Fannie and Freddie were run as for-profit companies. Their top executives made Wall Street-type salaries, pocketing tens of millions of dollars a year.

While Fannie and Freddie had been created by the government and ostensibly had a public purpose in promoting homeownership, there can be little doubt that profit figured most prominently in their business strategy. When Freddie decided to jump big-time into the subprime market in 2006 – just as it was collapsing – the motive was increasing market share and profit, as this Moody’s analysis makes clear.

The moral hazard problem of the pre-crisis Fannie and Freddie – private profit and public risk – was eliminated when they went into conservatorship. In the last five years they have been operated to sustain the housing market, together buying up more than 80 percent of the mortgages issues since the onset of the crisis.

Given that both are now covering their costs and making profits, which are arguably even too large, it’s difficult to see what the problem is. But President Obama wants to wind down them down and replace them with a new and ostensibly improved public-private system.

While we don’t know the details of what the new system will look like, the basic story is clear. Private banks like Goldman Sachs, Citigroup, Bank of America will again issue mortgage-backed securities (MBS). Unlike the MBS of the bubble years, these new issues will carry an explicit government guarantee.

In this new system there will be a requirement that investors in the MBS absorb some loss before the guarantee kicks in. This is supposed to ensure that they don’t game the system by pumping out MBS filled with junk mortgages. And the whole system will be carefully regulated.

Readers can be excused if they are feeling some seriously unpleasant déjà vu reading this. Yes, we have seen this movie before and we might already be in the second reel.

In the immediate aftermath of the crash there was a widespread insistence that MBS issuers would have to keep a substantial stake in the mortgages they put into MBS. Some were arguing that they should have to hold 20 percent of these mortgages on their own books. This quickly got whittled back to a much more modest 5 percent.

Then it was decided that high-quality mortgages with down payments of more than 20 percent would not require any reserve. The industry decided this was still too restrictive. They lobbied to have the requirement weakened so that issuers don’t have to hold reserves against mortgages with as little as 5 percent down, even though these mortgages defaulted at 3-4 times the rate of mortgages with 20 percent down in the years preceding the crisis.

Another highlight of the bubble was the gaming of ratings by the credit-rating agencies. It turns out this is back also. The New York Times reported last week that Standard and Poor’s had lowered its standards for rating commercial mortgage backed securities in order to get more business.

Dodd-Frank did have a provision to eliminate this problem. Senator Franken proposed an amendment under which the Securities and Exchange Commission (SEC) would select the rating agency rather than the issuer, thereby eliminating the incentive for rating agencies to shop for business with inflated ratings. Even though the Franken amendment passed overwhelmingly with bi-partisan support, the conference committee decided the SEC should study the issue.

After three years, and dozens of industry comments, the SEC issued its reportsaying that it lacked the ability to pick bond rating agencies. Therefore we’re back with the cesspool we had before the crisis.  In short, there is no reason to believe that current regulatory structure will protect us from the worst abuses of the bubble years.

What if we just forgot about the government guarantee and got the government out altogether. There’s a repeated refrain that this would mean the end of the 30-year mortgage. This is of course not true.

There are plenty of 30-year mortgages in the jumbo market which consists of mortgages too large to be purchased by Fannie and Freddie. The lack of a government guarantee adds 0.25-0.50 percentage points to their cost. There is no reason to think that we would not see a similar story for conventional mortgages.

At higher costs more people may opt for shorter term or adjustable rate mortgages, but so what? We don’t need to set up a complex government guarantee system to encourage people to buy 30-year mortgages; the point is supposed to be to promote homeownership.

That goal can be best served with Fannie and Freddie continuing as government companies. But if that looks too much like communism for the Washington folks, then let’s just shut them down and leave it to market. We don’t need to set up a Rube Goldberg system just so the big banks can rip us off yet again.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This article originally appeared on The Guardian.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

Like What You’ve Read? Support CounterPunch
Weekend Edition
August 28-30, 2015
Andrew Levine
Viva Trump?
Jeffrey St. Clair
Long Time Coming, Long Time Gone
Mike Whitney
Looting Made Easy: the $2 Trillion Buyback Binge
Alan Nasser
The Myth of the Middle Class: Have Most Americans Always Been Poor?
Rob Urie
Wall Street and the Cycle of Crises
Ismael Hossein-Zadeh
Behind the Congressional Disagreements Over the Iran Nuclear Deal
Lawrence Ware – Marcus T. McCullough
I Won’t Say Amen: Three Black Christian Clichés That Must Go
Evan Jones
Zionism in Britain: a Neglected Chronicle
John Wight
Learning About the Migration Crisis From Ancient Rome
Andre Vltchek
Lebanon – What if it Fell?
Robert Fantina
Hillary Clinton, Palestine and the Long View
Ben Burgis
Gore Vidal Was Right: What Best of Enemies Leaves Out
Suzanne Gordon
How Vets May Suffer From McCain’s Latest Captivity
Robert Sandels - Nelson P. Valdés
The Cuban Adjustment Act: the Other Immigration Mess
Uri Avnery
The Molten Three: Israel’s Aborted Strike on Iran
John Stanton
Israel’s JINSA Earns Return on Investment: 190 Americans Admirals and Generals Oppose Iran Deal
Randy Blazak
Donald Trump is the New Face of White Supremacy
Bill Yousman
The Fire This Time: Ta-Nehisi Coates’s “Between the World and Me”
Michael Welton
The Conversable World: Finding a Compass in Post-9/11 Times
Brian Cloughley
Don’t be Black in America
Charles Pierson
How the US and the WTO Crushed India’s Subsidies for Solar Energy
Kent Paterson
In Search of the Great New Mexico Chile Pepper in a Post-NAFTA Era
Binoy Kampmark
Live Death on Air: The Killings at WDBJ
Gui Rochat
The Guise of American Democracy
Emma Scully
Vultures Over Puerto Rico: the Financial Implications of Dependency
Chuck Churchill
Is “White Skin Privilege” the Key to Understanding Racism?
Kathleen Wallace
The Id(iots) Emerge
Andrew Stewart
Zionist Hip-Hop: a Critical Look at Matisyahu
Gregg Shotwell
The Fate of the UAW: Study, Aim, Fire
Halyna Mokrushyna
Decentralization Reform in Ukraine
Scott Parkin
Katrina Plus Ten: Climate Justice in Action
Norman Pollack
World Capitalism, a Basket Case: A Layman’s View
Sarah Lazare
Listening to Iraq
John Laforge
NSP/Xcel Energy Falsified Welding Test Documents on Rad Waste Casks
Wendell G Bradley
Drilling for Wattenberg Oil is Not Profitable
Joy First
Wisconsin Walk for Peace and Justice: Nine Arrested at Volk Field
Mel Gurtov
China’s Insecurity
Mateo Pimentel
An Operator’s Guide to Trump’s Racism
Yves Engler
Harper Conservatives and Abuse of Power
Michael Dickinson
Police Guns of Brixton: Another Unarmed Black Shot by London Cops
Ron Jacobs
Daydream Sunset: a Playlist
Charles R. Larson
The Beginning of the Poppy Wars: Amitav Ghosh’s “Flood of Fire”
August 27, 2015
Sam Husseini
Foreign Policy, Sanders-Style: Backing Saudi Intervention
Brad Evans – Henry A. Giroux
Self-Plagiarism and the Politics of Character Assassination: the Case of Zygmunt Bauman
Peter Lee
Making Sense of China’s Stock Market Meltdown