Freddie's Dead

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Dean Baker
The Guardian Unlimited, September 8, 2008

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The US government takeover of Freddie Mac and Fannie Mae shows why privatisation doesn't serve the public interest.

Fannie Mae and Freddie Mac finally kicked the bucket this weekend, with the Treasury department stepping in to take over the companies. The top management is being sent packing (albeit with multi-million dollar severance packages), and the shareholders will stop seeing dividends, probably forever.

These mortgage giants went under because they were somehow unable to recognise the housing bubble and to adjust their lending to protect themselves against the inevitable crash. Fannie and Freddie are very far from innocent victims. It is their job to know the housing market and to recognise a bubble. Furthermore, if Fannie and Freddie had begun to tighten credit five or six years ago, when house prices were already clearly out of line, they could have stopped the growth of the bubble before it reached such dangerous proportions.

That's all history now. The big question is what these institutions will look like going forward. There is a strong argument for keeping these institutions publicly run. In effect, both Fannie and Freddie can be operated as public corporations, which was the case with Fannie Mae prior to its privatisation in 1968.

The current disaster should not lead people to forget the benefits that these companies conveyed to homeowners. By creating the secondary mortgage market, they created first a national and then an international market for home mortgages. This had the effect of equalising interest rates across the country and making homeownership affordable to millions of families.

Perhaps the private sector would have created a secondary mortgage market on its own, but it didn't. Furthermore, private issue mortgage backed securities have performed far more poorly in the current crisis than the securities issued by Fannie and Freddie. This is why private issue mortgage backed securities have virtually disappeared over the last year, and Fannie and Freddie are now financing almost 80% of the new mortgages being issued. Those who tout the virtues of the private sector in the secondary mortgage market are arguing based on faith, not evidence.

There is still a very big need for Fannie and Freddie to ensure a well-operating secondary mortgage market. However, it is not clear what benefit we get by returning them to their mixed public-private status.

We want the private sector to take the leading role in most areas of the economy because we expect private sector entrepreneurs to be more innovative and more willing to take risks than public sector bureaucrats. This is why we don't want a federal computer agency or national auto manufacturer. The private sector will likely be far more effective at developing new and better computers and cars in a timely manner than the government.

By contrast, it is not clear that we really want a lot of innovation in the secondary mortgage market. The financial innovations in the mortgage market helped extend the housing bubble and are the basis of much of the financial turmoil now facing the country and the world.

We would have benefited enormously had Fannie and Freddie just operated in a conservative manner – buying up mortgages that met solid lending criteria, and packing them into standard mortgage backed securities. Fannie and Freddie's eagerness to keep market share, even at the cost of acquiring riskier mortgages, was the main cause of their bankruptcy. Their innovative private sector practices are likely to cost taxpayers tens of billions of dollars in this bailout, in addition to the much greater harm they caused to the economy by extending the housing bubble.

In the future, Fannie and Freddie can best serve their role of providing the stable anchor of the secondary mortgage market by being boring government corporations. As recent events make very clear, these companies are playing with the taxpayers' dollars. While the public guarantee of Fannie and Freddie debt is necessary to ensure the stability of the secondary mortgage market, there is no reason that this guarantee should apply to any investment on which their top executives choose to gamble.

Private banks would still be free to be creative and innovative in developing complex new mortgage derivatives, if they can find anyone to buy them. The difference is that the taxpayer would not be standing behind the private sector banks, prepared to absorb any losses even as the stockholders and top executives got rich off the gains.

The federal takeover of Fannie and Freddie will force a debate over their ultimate status. It is clear that many Republicans want to see them broken up and privatised, which has long been their explicit agenda.

The current crisis has shown the failing of Fannie and Freddie in their role as public/private hybrids. We should see that as reason for ending the private side of the equation. The only obvious value added by the private side is the tens of millions of dollars of compensation received by the CEOs. The CEOs can go to Wall Street if they want those salaries.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.