Fannie and Freddie: Fiscal Frauds

Those who fear that undue accumulations of power are destabilizing the American economy always seem obsessed with “market power” concentration. Witness the persecution of Microsoft. But proponents of government antitrust intervention should look closer to home. Some of the most serious threats are posed not by private firms, but rather by the strange entities known as “government sponsored enterprises” (GSEs), specifically the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. The first target of antitrust regulators should be to break up these artificial monstrosities.

Known popularly as Freddie Mac and Fannie Mae, these agencies were created to establish a secondary market for mortgages. It’s not too complicated: They purchase certain home mortgages meeting their investment criteria, so-called “conformity” mortgages. They bundle these and then issue new publicly traded securities based on the total mortgage portfolio. This securitization offers risk diversification and standardization to improve the economics of the mortgage market.

However, these GSEs might better be described as “government subsidized enterprises.” Freddie and Fannie do not have to pay state or local taxes, saving them hundreds of billions of dollars annually. They do not have to register with the Securities and Exchange Commission, a boon not available to most firms. Of course, their executives are compensated handsomely.

The agencies also have a $2.25 billion line of credit from the Treasury Department. Most significantly, the management and shareholders of Freddie and Fannie keep all profits (and those “profits” have been substantial in recent years) while seeing that losses are borne by taxpayers.

The basic task of a market economy is to allocate capital. The entrepreneur considers the available array of returns and risks, and then selects investments which he believes will yield the “best” return. But the peculiar institutions that are GSEs anesthetize the market’s response to risk, and end up distorting the allocation of capital.

The market values Freddie and Fannie not solely on their management skills, but rather on their implicit government guarantee. The market assumes that Freddie and Fannie are safer investments than other ventures. In order to keep their special advantages, Freddie and Fannie lobby government, buy off opponents, and blast away their critics.

Most companies find the money-making game a difficult one. But when you’re allowed to play with “Monopoly” money (and everyone else has to use the real thing), you can buy up all the houses and hotels—or in this case their mortgages—from Baltic Avenue to Park Place without “passing Go” (and without running the risk of “Going to Jail”). Monopoly money just makes it easy to become a monopolist. The rapid growth of Fannie and Freddie during the 1990s suggests that the agencies are well on their way to becoming just that.

Fannie and Freddie were created with good intentions, designed to further the “American dream.” Yet there are other American dreams than merely owning a home, such as having a job, starting a business, or sending your kids to better schools. These dreams also require capital–capital that Fannie and Freddie end up diverting into middle- and upper-class housing. For Fannie and Freddie to decide that housing is our only dream creates a nightmare for those with other dreams requiring capital.

Although Fannie and Freddie have championed affordable housing, they have done little to help the poor attain it. If anything, Fannie and Freddie probably raise the price of their mortgages (which the two institutions do not finance). This point was even made by the Department of Housing and Urban Development: “While Fannie Mae and Freddie Mac have been successful in providing stability and liquidity in the market for certain types of mortgages, their share of the affordable housing market is substantially smaller than their share of the total conventional conforming mortgage market.”

Distortions such as these place America at risk. They weaken the private sector institutions that still play an important mortgage financing role. They misallocate capital, raising the costs of acquiring capital for new business startups. They entangle commerce and government, leading to a situation akin to that of Europe where government-pampered banks are “too big to fail.” While some of the capital diversion lowers mortgage costs to those eligible for Freddie/Fannie purchases, at least one-third of it goes to their management and shareholders.

Economists call this phenomenon “moral hazard”–a situation where one takes more risks because one is not fully responsible for them. This phenomenon isn’t unfamiliar, as the IMF and World Bank have often demonstrated with their lending to developing countries. Freddie and Fannie destabilize the American financial system. That’s what moral hazard is all about: the unintended consequences of helping one American dream at the expense of all others.

How to correct this mess? The Department of Justice should be urged to develop a divestiture/breakup plan for Fannie and Freddie. Fannie Mae’s Vice-Chair Jamie Gorelick, after all, comes from the Department of Justice. Seasoned in the science of “trust-busting,” Ms. Gorelick might well assist in such a breakup.

If the federal government is willing to shatter Microsoft, a well-run, truly private firm, because it wasn’t willing to genuflect before antitrust chief Joel Klein and Judge Thomas Penfield Jackson, then the government certainly should be willing to disassemble these wholly artificial entities. Were Fannie and Freddie broken into four or so private  firms nationwide, each assigned a diversified share of the holdings of the current monopolies, privatization would be much less traumatic and far less risky politically.

Quasi-political and quasi-private, Fannie and Freddie blend the worst aspects of the two worlds: self-interest without responsibility, greed with non-accountability. Private firms can’t compete against Fannie and Freddie’s subsidized enterprise, and the agencies themselves are not held accountable to elected representatives.

At best, this mixing of private and political incentives creates marketplace confusion; at worst, it leads to increasing risk and lost opportunities for the American taxpayer. It’s past time to cut the apron strings and privatize these “infant industries.” It’s time they became capitalist adults.