When you’ve got a couple of zombies on your hands, your first instinct is to kill them. But when it turns out that if you let them live, every couple of months those zombies will write you a check for a few billion dollars, you might find it a little hard to pull the trigger.
U.S. policymakers find themselves in a similar situation with regard to the former Government Sponsored Enterprises Fannie Mae and Freddie Mac. The two mortgage market behemoths are “former” GSEs in the sense that for the past six years, rather than being sponsored by the federal government, they’ve been its wholly owned subsidiaries.
Washington had to bail out Fannie and Freddie when the mortgage market tanked during the financial crisis in 2008, and it put them in a “conservatorship” overseen by the Federal Housing Finance Administration (FHFA). As part of the deal, their profits go straight to the U.S. Treasury.
At the time of the bailout, the financial markets were in such disarray that the continued functioning of Fannie and Freddie was just about the only thing making it possible for many people to get mortgage loans. So the Bush and Obama administrations allowed them to continue operating, with the general assumption that they would eventually be either privatized in some fashion or wound down.
However, by virtue of being the only game in town, the GSEs’ dominance in the regular consumer mortgage securitization business became practically complete. This created a problem. While the government, then as now, wanted to see the private market step up and take over the role played by the GSEs, the government’s ownership of the two companies made it practically impossible for private firms to compete.
Investors who buy the mortgage-backed securities sold by Fannie and Freddie view them, quite rightly, as backed by the federal government. There’s a significant premium people will pay for an investment perceived as being guaranteed by the full faith and credit of the United States, and there aren’t a whole lot of private companies that can inspire the same confidence. That means competitors can’t borrow money at the same rate as Fannie and Freddie, and therefore can’t compete with them on pricing.
So far, this hasn’t been bad news for the U.S. taxpayer.
The government spent a fortune to bail out the GSEs, money that many viewed as lost at the time. In the years since, though, they have paid the Treasury back with interest, and continue to pump billions back into government coffers every quarter.
What seems like a sweet deal for the taxpayer is actually quite dangerous. Under the terms of the deal, the GSEs were prevented from establishing a significant capital base. That means that they have little or no reserve against a downturn in the housing market. As Ed DeMarco, who ran the FHFA from 2009 until earlier this year put it at an event hosted by the Bipartisan Policy Center on Monday, the agreement means that Fannie and Freddie must operate on terms that leave them “barely solvent.”
That also means that, in the event of another mortgage market crisis, the U.S taxpayer is on the hook for the companies’ losses.
The result is a genuine dilemma for federal policymakers. They would, in general, much prefer to have the risk of financial loss from another mortgage crisis be absorbed by the private sector. But in order to create breathing space for a viable private option to the GSEs, they need to either raise prices for mortgage guarantees to a level at which their pricing advantage disappears, or shut Fannie anf Freddie down altogether.
“Conservatorships are a huge barrier to entry,” DeMarco said. “It’s very hard to compete with the conservatorships.”
The other problem is that, while currently dominant in the part of the mortgage market they serve, the GSEs are not really being run as businesses, but as wards of the state. With no capacity to build capital and little ability to invest in their future, they are not positioning themselves for changes in the market they way that a normal business would.
Major decisions are dependent on the government, which still views the GSEs as entities whose continued existence is, at best, temporary.
The result is that important decisions about the future are either delayed or never taken at all.
As former Federal Housing Finance Board chairman Bruce Morrison put it at the Bipartisan Policy Center event, “There is no such thing as standing still. Decisions or non-decisions have consequences.”
Worse still, their dominant position in the market means that lenders are forced to tailor their loans to fit the GSEs standards, which are not likely keeping up with innovations in the markets.
The GSE zombies may not be eating the brains of their potential mortgage market competitors, but there is a strong argument that they are killing them off through atrophy – and there’s not much difference.
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