Reforming Fannie and Freddie: No Escape for Taxpayers

Arguably the most glaring hole in Congress' financial reform is its utter failure to impose any changes for Fannie Mae and Freddie Mac. Some amendments were offered to tackle the government-sponsored entities, but all were voted down. So the question remains open: what should be done with these troubled firms? One proposal comes from Georgetown Professors Donald B. Marron and Phillip L. Swagel via a piece at The idea is interesting, as it intends to create a way for the government to promote home ownership without taxpayers paying the price. Unfortunately, that's not possible.

The Key Premise

First, in order to proceed you have to accept the premise that the government should be involved in promoting mortgages. While that assertion isn't at all obvious, refuting it would be a task for another time. Marron and Swagel attempt to create a more stable mortgage market where the government is still there to ensure mortgage availability.

The Plan

Their plan is most clearly summed up by the great diagrams they provide. So let's start there and then work out the details. Here's how they explain how conforming mortgage market worked traditionally:

GSE plan 2010-05 cht1.PNG
In the diagram, banks and other lenders provide mortgages to borrowers. Fannie and Freddie then purchases or insures them. Some get securitized into mortgage-backed securities (MBS), while the mortgages the GSEs keep are backed by agency debt. So investors ultimately provide the cash to fund these mortgages in either case.

The problem with this system is the government's role. It implicitly guaranteed the GSEs. That resulted in moral hazard for Fannie and Freddie. They made huge profits at the taxpayer's expense, since the GSEs could take risk without having to worry about losses.

Here's how Marron and Swagel suggest changing things:

GSE plan 2010-05 cht2.PNG

The first step would be to introduce competing securitizers. They would presumably be investment banks that would also create MBS. Fannie and Freddie are privatized and also act in this capacity, with no government backing. Next, the government's role changes. It now directly and explicitly insures the MBS instead of Fannie and Freddie. The securitizers pay a fee to the government that acts as a sort of insurance premium. The authors say that the fee should be actuarially fair, i.e. it should accurately reflect the risk the mortgages contain. These fees would exist to form a fund meant to cover any losses that the government takes on bad MBS. That way, taxpayers wouldn't be on the hook. Investors, of course, would love this MBS, because it would be as safe as Treasuries. There would be plenty of liquidity.

Problem #1: This Already Failed

During the housing boom, not all mortgages were guaranteed by Fannie and Freddie. Some were non-conforming, and still securitized by banks to create MBS. Many of these were also guaranteed by bond insurers, who collected a premium to cover potential losses -- just like the plan above wants the government to do. Now, those bond insurers are hanging by a thread, as they incurred huge losses because they mispriced the risk in the mortgages they backed.

What makes us believe that the government can do a better job of pricing risk than private firms who actually cared about losing money? What would probably happen, at some point in the future, is that the government will realize that it wasn't charging enough for the risk, and taxpayers will bear the cost of an MBS bailout.

Problem #2: The Government Must Misprice the Risk

But let's take this a step further. The government would have to intentionally charge insufficient fees: it must put too low a price on the risk for its presence in the mortgage market to serve any purpose.

Think about this for a minute. If the government priced insurance premiums to accurately reflect the risk inherent in these bonds, then it wouldn't be subsidizing the housing market. Why would it bother even having a presence then? If taxpayers never take a hit, then homeowners gain nothing by the government's involvement in the mortgage market.

Imagine two scenarios. The first has the plan above in place. $100 million of mortgages are originated. The government charges an insurance premium of 5% or $5 million. Investors buy the other $95 million in bonds. Ultimately, the aggregate loss to the government is precisely $5 million, as anticipated.

In scenario two, there's no government involvement in the mortgage market. Now, investors need to worry about the risk. As a result, they demand a discount on these mortgages equal to the loss the MBS will incur. As explained before, it's equal to 5% or $5 million. They pay $95 million for the bonds.

As you can see, the only way that the government can increase liquidity in the market is if it purposely charges too little to cover the risk. For example, if it charges $2 million instead of $5 million, then that $3 million subsidy will increase home ownership by paying for higher risk mortgages that wouldn't have otherwise been originated. Taxpayers ultimately have to pay for that $3 million, of course.

This boils down to an important point: there's no reason to have the government involved in the mortgage market unless you intend to create a subsidy. That would provide more homeownership. This may or may not be a worthwhile end for taxpayers, depending on your view of the world. But the fact that taxpayers will bear the cost is inescapable.