Fannie & Freddie's Guarantee: A Self-Fulfilling Prophecy?

The Government Accountability Office (GAO) has a new report (opens .pdf) out this week analyzing the options for what to do about Fannie Mae and Freddie Mac. The document is rather in-depth, but essentially considers three options:

Reconstitute the enterprises as for-profit corporations with government sponsorship but place additional restrictions on them.


Establish the enterprises as government corporations or agencies.


Privatize or terminate them.



I lean strongly towards the final option. The report presents one amusing, though legitimate, obstacle to it.

First, about privatizing/terminating, the report notes:

Some analysts and financial commenters contend that privatizing, significantly reducing, or eliminating the enterprises' presence in the mortgage markets represents the best public policy option. Advocates of this proposal believe that it would result in mortgage decisions more closely aligned with market factors and reduce safety and soundness risks. That is, sources of mortgage credit and risk would not be concentrated in two large and complex organizations that might take excessive risks because of the implied federal guarantee on their financial obligations. Instead, mortgage credit and risk would be diversified throughout the financial system. Federal Reserve Chairman Ben S. Bernanke has suggested that privatized entities may be more innovative and efficient than government entities, and operate with less interference from political interests.



Can I get an "Amen!"? In the long-run, privatizing or eliminating these entities should benefit the economy for exactly those reasons cited. Yet, the report goes on to explain an amusing, but very real problem with attempting privatization:

Given the substantial financial assistance that Treasury and the Federal Reserve have provided to the enterprises during their conservatorships, it may be very difficult to credibly privatize them as largely intact entities. That is, the financial markets likely would continue to perceive that the federal government would provide substantial financial support to the enterprises, if privatized as largely intact entities, in a financial emergency. Consequently, such privatized entities may continue to derive financial benefits, such as lowered borrowing costs, resulting from the markets' perceptions. In exploring various options for restructuring the enterprises, Bernanke has noted that some privatization proposals involve breaking the enterprises into smaller units to eliminate the perception of federal guarantees.



What they're talking about would probably go something like this:

One day, probably in the too-distant future, a banker reads the Wall Street Journal headline proclaiming "Private Sector Welcomes Back Fannie and Freddie." He chuckles. Later that day, around the water cooler, he sees his buddy, the mortgage-backed securities trader. He says, "So, Fannie and Freddie aren't guaranteed by Uncle Sam anymore. How's the market handling that news?" He replies, "Oh please. If we see another crisis like we did back in 2008, you wait and see how fast the government swoops in and rescues them. Investors understand that, so their bonds are still trading at approximately the same spreads to Treasuries."

The government's guarantee of Fannie and Freddie is something of a self-fulfilling prophecy. If the market believes it, then it must be true. This might seem odd, but if banks and investors continue to assume an implicit guarantee, then they'll continue to allow the agency to be a dominant force in the housing market. If they didn't, the market would force it to shrink, as it would have far fiercer competition with other firms who purchase and securitize mortgages.

Bernanke's solution to this problem might work, but I think there's a cleaner one: gradually shrink Fannie and Freddie. Imagine, for example, if the agencies shrunk by a few hundred billion each year for 10 years. Right now, they own or guarantee around $5.4 trillion in mortgages. That would cut their size in half over that time period. Then, you have two options:

You could continue the process for several more years and eliminate the agencies entirely.

You could more easily bring them private once they've become small enough to become less systemically risky. At that point, the market would be more easily convinced that they would not need to be saved if they failed.

I think the problem of this sort of self-fulfilling prophecy is genuine, but I don't think it's that difficult to solve. I also don't like the thought that it could be used as an excuse for allowing Fannie and Freddie to live indefinitely as some form of government organism. If there's a legitimate economic reason brought to light why the government must remain involved, then that's fine. But don't try to say there's a sort of metaphysical logic trap that prevents any other alternative. That's nonsense.