The Future of Fannie and Freddie

Fannie Mae (FNM) and Freddie Mac (FRE) have never seemed more indispensable than in the current credit crisis. They are the last nongovernmental players standing in the business of buying mortgages. On July 15, Treasury Secretary Henry M. Paulson Jr. asked Congress for unlimited authority to lend to them to reassure markets of their creditworthiness. He compared the requested credit line to a bazooka he hopes will never have to be used.

Oddly, though, the very fact that policymakers are bending over backwards to protect Fannie Mae and Freddie Mac makes it all the more important to talk about whether they should, in the long run, live or die. When this crisis is over, should these quasi-public, shareholder-owned companies be nationalized? Privatized? Closed down entirely? Or left essentially intact, except perhaps with smaller portfolios and tighter regulation? The emerging debate will sweep up a wide range of issues, from Fannie and Freddie's implication in the housing bubble to national competitiveness.

It may seem premature to plan for a restructuring in the middle of an emergency, but short-term fixes could have harmful consequences if they wind up being permanent. Peter D. Schiff, the head of brokerage Euro Pacific Capital, says Paulson's "bazooka," by propping up Fannie and Freddie, would allow them to buy "more mortgages on overvalued homes," with U.S. taxpayers and foreign dollar holders ultimately picking up the tab.

Questions about the proper role of Fannie Mae and Freddie Mac have come to a head because the companies lost the confidence of investors at the moment they were most needed—when other mortgage buyers had gone on extended holiday. The Treasury Dept. and Federal Reserve made emergency statements of support on Sunday, July 13, for fear that without their explicit backing the firms might not be able to keep raising money. Worries that a potential government takeover or restructuring would wipe out shareholders have driven the two companies' stock prices down nearly 90% over the past year. The market consensus now is that the two companies don't have the resources to survive a severe market downturn without government backing.

The fate of Fannie and Freddie is hugely important because the two have grown to dominate the U.S. mortgage market. Fannie dates back to the Depression year of 1938; Freddie to 1970. Although they don't originate loans, they own or insure about 40% of the $11 trillion in residential mortgages in the U.S., according to Inside Mortgage Finance, a trade publication.

From an economic perspective, the chief complaint is that Fannie and Freddie exacerbate swings in the housing market instead of dampening them. In the boom that began around 2000, Fannie and Freddie formed a critical link in the transfer of savings from countries like China and Japan to home buyers in America. They packaged their debt conveniently to resemble U.S. Treasuries, and although the debt didn't carry the explicit backing of the government, many foreign buyers assumed—correctly, it turns out—that the government wouldn't let Fannie and Freddie default. China alone owned $387 billion of securities of Fannie Mae, Freddie Mac, and other government-sponsored enterprises as of mid-2007, or 27% of the total owned by all foreign countries.

Homes But No Jobs

In short, Fannie and Freddie were not just passive bystanders in global capital flows. Says Brad W. Setser, a fellow at the Council on Foreign Relations: "The agencies became a mechanism that allowed the U.S. to transform a pool of mortgages, which wouldn't be a classic central bank asset, into a set of assets that foreign central banks found attractive." It's possible, says Setser, that if not for the two companies, more foreign money might have gone into corporate bonds. That would have meant more investment by U.S. companies in capital equipment—and less in housing, which does little to boost U.S. competitiveness. As it is, too many Americans have beautiful homes but no jobs.

When the bust came, Fannie Mae and Freddie Mac kept packaging mortgages for sale even after others had gotten out of the business. But they were also losing money. And because they were thinly capitalized, it didn't take big losses to make investors worry about two stocks long viewed as bulletproof.

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