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It is now consensus that Fannie Mae and Freddie Mac are
at the heart of the systemic meltdown we are seeing in the mortgage
market. They are costing taxpayers billions through their own bailouts
and through the role they played in fueling an artificial mortgage boom.
eight years ago, when I testified before Congress that Fannie Mae and
Freddie Mac's "special privileges create a serious hazard to the
market, to taxpayers (and) to the economy," my criticism of these
sacred financial entities was met with ridicule.
At the hearing on June 21, 2000, before the House Financial Services
Committee, I called the government-sponsored enterprises "strange
organizations, neither private- sector fish nor political-sector fowl"
and said that "as a result, no one is quite sure how these entities
should be evaluated or held accountable."
I offered my opinion that the rapid growth of their debt portfolios
and the new risks Fannie and Freddie were taking on — such as the
purchase of various unproven mortgage instruments — "will certainly
increase the likelihood of a Fannie-Freddie default."
The Martians Are Coming!
Reviewing the hearing transcript, I see that some congressmen,
notably Paul Ryan of Wisconsin and Richard Baker of Louisiana, shared
my concerns. But to boosters of the mortgage giants from both parties,
it was as if I and others at the hearing offering similar warnings on
behalf of the free-market National Taxpayers Union and Citizens Against
Government Waste were heralding an invasion from outer space.
"Mr. Smith, that is almost a fallacious argument," Rep. Paul
Kanjorski, D-Pa., said in pooh-poohing my testimony. He then proceeded
to explain to me that the rapid growth of the GSEs' debt holdings was
nothing to worry about, because it was simply reflecting "inflation and
the growth of population" and economic growth itself. "Everything,
proportionately, is that much larger."
Similarly, then-Rep. Marge Roukema, R-N.J., touted the complex
capital rules governing the GSEs, saying that "very few banks or
S&Ls could, even in this day and age, even now, meet the
stress-testing requirements which Fannie and Freddie are required to
And Rep. Carolyn Maloney, D-N.Y., offered a fairly typical response
from GSE defenders to my concerns about the long-standing line of
credit of $2 billion from the Treasury Department. "It is really
symbolic, it is obsolete, it has never been used," she declared.
She asked, "Would you explain why it would be important to repeal something that seems to be of little use?"
I answered that "as long as the pipeline is there, it is like it is
very expandable." Then, in what even I thought might be a reach, I
added, "It is only $2 billion today. It could be $200 billion tomorrow."
"Tomorrow," of course, arrived early this month. That's when
Treasury Secretary Henry Paulson announced that the GSEs will be put
into a government conservatorship, and that the Treasury Department
will make routine injections into the GSEs of what is expected to be
tens of billions of taxpayer dollars.
Unfortunately, my estimate of a $200 billion taxpayer cost back then may yet turn out to be too low.
But out of every crisis comes opportunity. And this crisis presents
the opportunity to ensure that Fannie and Freddie will never pose a
risk to the taxpayer, or an even worse systemic risk to the economy,
While they are under the government conservator, policymakers should
move forward on what is the only option that will guarantee a permanent
end to these risks: an orderly liquidation.
Back in 2000, I urged Congress in my testimony "to develop a
divestiture or breakup plan for Fannie and Freddie." I suggested that
lawmakers "create a liquidation plan that would plausibly avoid a
bailout if and when the next economic crisis occurs."
The good news is that just in the past few weeks, the debate has
largely moved beyond Fannie and Freddie's hybrid public-private
structure. Across the political spectrum, there is recognition that the
GSE model of privatization of profit, yet socialization of risk, is
As Sen. Barack Obama recently said on the campaign stump, "We can't
have a situation in which, during boom times, management and investors
are soaking up huge profits, taking extraordinary risks, and thinking
to themselves that somehow the taxpayers are going to be there to bail
The real question now is why we need any mortgage-buying entities —
government, private, or in-between — of Fannie and Freddie's
That housing is central to the U.S. economy, as Paulson and others stress, is somewhat of a circular argument.
Housing became so intertwined with the financial system because of
Fannie and Freddie's privileges as well as other subsidies premised on
the die-hard conviction of many lawmakers that every American should
own a home.
Politicians call homeownership the "American dream," but there are many other "dreams" Americans pursue in the credit markets.
There is no reason to distort this market in favor of housing above
other economic activities. There are no Freddie and Fannie-like
entities for auto loans and commercial real estate mortgages, yet
financing in these areas has still evolved.
And notably, while these credit markets are now stressed, they have
not faced a systemic collapse such as that of the home mortgage market.
By virtue of their sizes, the GSEs helped create the very systemic risk they were created to protect the housing sector from.
In 2000, I argued that after a crisis occurs, the problem would be
"too difficult to fix" because "the pain would be too great." On this
point, I hope I was wrong.
Although the pain to taxpayers and the economy will be great, with
the right policy focus, the GSE problem is still not too difficult to
fix. We must realize, however, that the only way to really "fix" Fannie
and Freddie is by breaking them into eventual nonexistence.
This article originally appeared in Investor's Business Daily .