How Congress should fix Fannie Mae and Freddie Mac

How Congress should fix Fannie Mae and Freddie Mac
Congress needs to break up both Fannie Mae and Freddie Mac and allow them to be replaced with a much larger number of genuine private sector companies
Tuesday, July 15, 2008By David C. John
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Sunday's announcement by the Bush Administration and the Federal Reserve seems to have cooled the immediate crisis concerning Fannie Mae and Freddie Mac. However, their plan does nothing to resolve the fundamental cause of the problem, and without major structural reforms in the housing finance industry, it is probable that this whole situation will reoccur in a few years.While both Fannie Mae and Freddie Mac are owned by private stockholders, they are really artificial government creations that are very different from real private sector companies. Both companies are remnants of the Great Society, when big government entities were thought to be the only way to achieve social goals. The fact that both were later privatized does not change their essential nature as government-sponsored dominators of a market rather than as participants in it. Both have a history of financial and management irregularities that have caused sudden changes in senior management and often sparked congressional action. Unfortunately, these problems have not resulted in any significant reforms to the overall structure of either entity.Background to a CrisisExperts have warned for decades that both entities lack sufficient capital, made up of both investors' money and retained earnings, to protect against losses.[1] While most banks have $1 of capital for every $12 in assets, Fannie Mae and Freddie Mac only have $1 for every $20 in assets. Congress looked at higher standards in the 1990s, but many of the same congressional leaders who head their oversight committees today bowed to a sustained and high-powered lobbying campaign that took all the teeth out of the reform. Other reform efforts have been similarly stymied.Fannie Mae and Freddie Mac play a dominant role in today's housing finance market by buying mortgages from lenders, packaging them into bond issues, and then reselling them to investors around the world. The two have a roughly 70 percent market share in this area, and also both guarantee mortgages and hold about $5 trillion worth of them in their investment portfolios. To operate, both entities need to borrow billions of dollars on a continuous basis. This most recent crisis was caused by concerns that an accounting rule change would sharply reduce their capital, which caused a sharp and continuing drop in their stock prices, which in turn frightened lenders and forced the government to act.