Should Big Banks Take Over for Fannie and Freddie?

The new year is not even a month old, but we may already have a contender for the very worst idea of 2011. Big banks are lobbying to take over where government-sponsored enterprises Fannie Mae and Freddie Mac left off, reports Louise Story in the New York Times. They want to be the ones to issue government guarantees going forward. This terrible proposal would essentially create a new housing policy framework just as toxic as it was under Fannie and Freddie.

What precisely does Story say banks are suggesting? First, banks assume that the government will continue to stand behind most mortgages in the U.S., as it has in the past. They think this because they've said that they won't stand for anything else. They have threatened to stop originating 30-year mortgages without a government guarantee in place.

So if the government does backstop mortgages, there just remains a question of who issues that guarantee against mortgages. In the past, Fannie and Freddie had this responsibility. We all know how that turned out.

The chances that Fannie and Freddie will survive housing policy reform are relatively slim at this point. They're pretty politically poisonous entities, and the public would likely be outraged if they continue to exist in a new form after their rescue, the cost of which is around $150 billion and rising. One possible scenario is for the GSEs to be wrapped up into a new government agency that issues mortgage guarantees and collects some insurance premium for federal backing.

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Banks would rather take on this responsibility, however. And who can blame them? Imagine if someone with seemingly infinitely deep pockets told you that they would insure whatever promises you made. Even beyond the transactions fees the banks could tack onto guarantee issuance and subsequent securitization, this responsibility might allow them more power to price the mortgages very cheaply, because they may decide which mortgages get guarantees.

From a policy perspective, however, this is an awful idea. It would put us right back where we were during the crash. Fannie and Freddie failed because you had publicly traded, profit-seeking firms issuing a government guarantee to price mortgages. In the framework banks propose, you would have precisely the same situation, but with different players. Instead of Fannie and Freddie, you would have big publicly-traded, profit seeking banks issuing a government guarantee to price mortgages. The names change, but the moral hazard stays the same.

In a few weeks, we'll be learning exactly what the Obama administration suggests should be done about U.S. housing policy, when it releases a big report on the issue. At that time, we'll see if the Treasury intends to support the idea that banks should issue government guarantees. If former Treasury official Michael Barr's opinion is any indication, then banks will be disappointed. In Story's article he senses a similar conflict arising as existed with Fannie and Freddie's dual role. Let's hope his former colleagues in the Treasury agree.