The Giants Fall:

Eliminating Fannie Mae and Freddie Mac

Raj Date

The Cambridge Winter Center for Financial Institutions Policy, in conjunction with the Roosevelt Institute’s conference on financial regulatory reform entitled “Make Markets Be Markets”, is pleased to present this research note.  A version of this note appears a chapter in the conference materials.

The bailout of Fannie Mae and Freddie Mac may be the most costly element of the Bush and Obama Administrations’ efforts to rescue the financial system.  It is tempting to pin the firms’ failures on their mission to promote affordable homeownership.  But that would be, in large measure, a misdiagnosis:  the subprime fraction of the GSEs’ credit exposure was too small, and the GSEs’ overall credit deterioration too large, to attribute their woes to the affordability mission alone.

The cause of the GSEs’ failure is actually more simple, and decidedly more troubling:  the very structure of the GSEs created the inevitability of their ultimate collapse.

Fannie and Freddie’s central concept -- the provision of guarantees on mortgage pools by government-sponsored private firms -- is fatally flawed.  Credit markets are prone to cyclical errors, even under the best of circumstances -- that is, even when credit decisions are undertaken by independent, atomized lenders who are checked by attentive and self-interested debt market investors.  But Fannie and Freddie, by design, do not labor under those ideal circumstances:  they are subject to no meaningful debt market discipline whatsoever, because their investors can and do rely on implicit taxpayer support.  Even with the most talented of management teams and the most energetic of regulators, and even without any mission-driven pro-homeownership bias, such a credit decisioning system is doomed to fail.

The GSEs do provide benefits beyond credit extension:  liquidity support, and interest rate risk absorption.  But those benefits are almost entirely the result of the GSEs’ taxpayer backing, so they can be supplied through more transparent, less costly means.  As a result, there is no logically defensible reason for the GSEs’ survival.  They should be eliminated.