Lynne Kiesling
I am not sufficiently expert in financial markets to opine on the current state of affairs in mortgages, mortgage-backed securities, banks, and so on. Hearing the current state of financial affairs at the two quasi-public financial institutions Fannie Mae and Freddie Mac, as well as the cacophonous din of those inveighing Congress and the Department of Treasury to “do something” because these two organizations are “too large to fail”, my first thought is this:
What purpose do Fannie and Freddie really serve? Due to the perverse incentives facing them, are they really forces acting in the market for stability, or are they gasping under the weight of the consequences of their own moral hazard? Instead of propping them up, shouldn’t we be paring down such incursions into market manipulation?
But, as I am not expert in this realm, that is simply my general economist-y perspective. Fortunately, Gerald O’Driscoll is more expert than I, and he has made some very insightful observations and recommendations in today’s Wall Street Journal. For my part, here’s the meat of his argument:
By last week, both corporations were operating at odds with their own charters. Consider Freddie Mac, chartered by Congress in 1970. Its first stated purpose was “to provide stability” in the secondary mortgage market. Its second purpose (of four) was “to respond appropriately to the private capital market.” But Freddie and Fannie had both become a source of financial market instability, helping to drag down share prices of other firms exposed to their obligations, and forcing private capital markets to respond to their possible collapse.
Whatever the outlines of what will inevitably be a hastily crafted bailout plan, the result must be true privatization. That means no more government lifeline: no Treasury line of credit, no Fed line of credit.
If the government takes an equity stake in the companies as part of a bailout plan, there needs to be a time line to end government ownership. Freddie and Fannie must cease to be “special,” and become quite ordinary.
They must also be downsized, because institutions so dominant in housing cannot be truly private. Additionally, as banking expert Bert Ely has pointed out, Freddie and Fannie have bulked up their balance sheets by taking on excessive interest-rate risk. Like savings and loans in the 1980s, Fannie and Freddie have maturity mismatch – borrowing short and lending long.
His recommendations for how to make Freddie and Fannie more ordinary? Downsize them, remove them from their inexplicable role in campaign finance funding, and increase their capitalization levels to those typical for commercial banks. Any capital injection from taxpayers in the form of Treasury instruments come with finite terms and clear, transparent sunsetting rules.
Most important of all, I think, he notes that a government-funded financial duopoly for ensuring liquidity in housing markets is obsolete. Hear, hear!
As nearly every responsible commentator has observed, Fannie and Freddie urgently need more capital. Thus we have an overall diagnosis and treatment plan: downsizing and capital infusions. In the near term, the capital may come from Treasury because of the dire condition of their share prices. Congress could authorize the Treasury to purchase shares of preferred stock convertible into common shares in, say, five years, but it would have a mandatory conversion feature in 10 years. At that point, the Treasury should be required to sell its common stock in an orderly fashion (but within two years). Socialism in housing finance must not be made permanent.
Over the course of the 10-year period, Fannie and Freddie should systematically sell off their security portfolio and raise additional capital. By the end of that period (or sooner, if management desires to get out from under the government’s yoke), their capital ratios should be up to the level of a commercial bank: 6%-8% of assets.
Follow these guidelines and at the end of 10 years, perhaps sooner, we could have a truly competitive market in housing finance. No single institution, nor a duopoly, would play a crucial role in housing finance. The idea that a government-sponsored enterprise is needed to provide liquidity is at best obsolete. Global financial markets provide liquidity, except when impeded by the effects of bad, government-directed policies. Credit allocation and easy money created a housing mess that now threatens the viability of even government-sponsored enterprises. Never again.
Dare we have a hope that financial policymakers will follow such mundane, sensible advice? Since it neither retains the political power that has taken up shop in Fannie and Freddie, nor reinforces the political power of either Treasury or the Fed (or Congress), I cynically anticipate that nothing this sensible will actually be allowed to happen.
To quote Arnold Kling, this current fiasco is a failure of central planning that, sadly, is likely to result in even more invasive (and ultimately destructive, in terms of economic well-being) central planning.
The right thing to do is to remove the pernicious and counter-productive forces that Fannie and Freddie have become. I fear that neither the political will nor the strength of integrity and leadership exist in Washington to enable that to happen and to un-yoke financial markets from this obsolete duopoly.
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