Fannie Mae (FNMA)

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Nine years after the crisis, Fannie and Freddie remain unfixed

by Thomas Aiello and Pete Sepp | Sep 19, 2017, 12:01 AM



This month marks the ninth anniversary of the start of the Great Recession. And today, the U.S. economy still remains susceptible to a pair of major drivers behind that crisis: Fannie Mae and Freddie Mac.

As the crisis exhibited all too clearly, the government-sponsored enterprise duopoly system creates systemic risk for everyone, most notably to taxpayers, who have paid out trillions in bailouts. Congress must act to reform these two giant government-sponsored enterprises in order to prevent future taxpayer-funded bailouts and protect the savings of American families.

Fannie and Freddie do not make loans. Rather, they buy mortgages from banks. The transaction flushes capital back into the banks, allowing them to originate more mortgages.

While this does provide liquidity to the financial services industry, the risk of default shifts to the GSEs, which is essentially backstopped by the taxpayer.

Up until 2008, both Fannie and Freddie enjoyed an implicit backing by the federal government (i.e. the taxpayer) as they bought up shaky primary mortgages. And cheap capital caused by loose monetary policy led to the vast purchases of mortgages. Between 1990 to 2003, the holdings of Fannie and Freddie went from 5 percent of the nation's mortgages to over 20 percent. By 2007, they held over $5 trillion in mortgages, about the size of the entire public debt of the U.S. government at the time.

Fannie and Freddie's growing involvement in the housing market ultimately undermined the stability of both GSEs and of the entire market. As they enabled a greater number of subprime buyers to purchase houses they could little afford, they inflated a bubble that was bound to collapse. By 2008, nearly 30 percent of their purchases fell into the box of "subprime mortgages" and had accrued an unprecedented debt of nearly $8 trillion.

We all know what happened next. The bubble burst and threatened the global economy. The consequences of the crisis sting no matter how many years go by: 10 million families had their home foreclosed; 8.8 million workers lost their jobs, and the economy suffered a hit of nearly $20 trillion. In a desperate move to ensure their solvency and prevent a complete meltdown of the economy, Congress wired the GSEs $187.5 billion in taxpayer funds and placed them into conservatorship, where they remain to this day.

The fifty-fifty model of "heads, companies-win or tails, taxpayers-lose" is an untenable position. As it currently stands, taxpayers are guaranteeing more mortgage debt today than they were in 2008. Housing finance reform must continue a transition away from taxpayer capital towards a system based upon private capital that protects taxpayers and reduces moral hazard through market discipline.

This requires instituting reforms that insulate taxpayers from losses incurred by risky behavior. There are many specific options to consider, but broad consensus exists among experts that private sector capital in the mortgage market must increase while government's role must decrease.

Additionally, reforms ought to strengthen the liquidity and stability of the primary and secondary mortgage markets. If policymakers decide that Fannie and Freddie are necessary, or a comparable body replaces the GSEs, guardrails must be constructed to limit the risks not only to taxpayers, but the financial sector as well.

Finally, reforms must create a market structure that eliminates barriers to entry, and thereby fosters an atmosphere of competition and innovation among financial products. Consumers will be the biggest beneficiary of competition as it improves service, drives down costs, and weeds out inefficiencies in the market. Further, the laws of economics dictate that competition is nearly always a superior system than a government-sponsored solution. It all begins, however, with protecting taxpayers.

Given that 75 percent of newly written mortgages are backed by taxpayers, it is imperative that Washington's leaders achieve a solution before the next housing crisis hits. Markets may appear secure and stable, but everything could change in an instant. Unpredictability, as we have seen in the last housing crisis, can cause lasting damage, and swift action is needed to get taxpayers off the hook before they are left with another GSE bailout bill.