Washington is renowned for having a short memory, so as Congress considers what to do with Fannie Mae and Freddie Mac, we taxpayers must remind it of the harmful role the duo played in the subprime mortgage meltdown. Congress authorized these government-sponsored entities, or GSEs, to purchase mortgages from banks and other originators and package them into securities with guaranteed payments for investors. That was supposed to expand the amount of investment flowing into mortgage finance, making it easier and cheaper for middle-income families to buy homes. But as for-profit entities, the GSEs discovered they could make big bucks operating essentially like giant hedge funds, issuing cheap debt with implicit government backing and investing the proceeds in high-yield, high-risk mortgage securitizations issued by Wall Street. They made zillions for their shareholders and management until, of course, the housing market turned and mortgage defaults skyrocketed, leaving their highly leveraged operations insolvent and wards of the state.
Taxpayers dumped nearly $190 billion into them to keep them functioning. They have paid back about $146 billion, since they can now easily generate profits through what are effectively government monopolies issuing mortgage securities 100% backed by taxpayers. Indeed, under Uncle Sam’s stewardship, their market share has grown to 75%, compared with less than 50% before the crisis.
There appears to be genuine bipartisan consensus to abolish the GSEs. But with both companies generating healthy profits for our cash-starved government, that consensus might not last. Senators Bob Corker (R-Tenn.) And Mark Warner (D-Va.) Have proposed legislation to replace the GSEs with a new government agency called the Federal Mortgage Insurance Corp., or FMIC. (Memo to Washington: Could you stop with the abbreviations already?) This agency would charge a hefty fee to guarantee mortgage-backed securities, similar to the way the FDIC charges premiums to insure bank deposits. Importantly, the FMIC wouldn’t pay a dime until mortgage bundlers or investors absorbed the first 10% of losses. So if FMIC guaranteed $5 trillion in mortgage securities (the likely size of an FMIC-backed market), it wouldn’t pay until private interests absorbed $500 billion of losses.
By requiring a 10% deductible, the bill limits the government’s exposure to major downturns in the mortgage market. That protects taxpayers and also improves market efficiency, as it forces private capital to ante up first. Not surprisingly, some mortgage industry lobbyists are whining about putting up that much capital. (It doesn’t seem to bother them that taxpayers are at risk for the next $4.5 trillion.) With about $20 trillion in U.S. Equity markets, $500 billion doesn’t seem an impossible lift. And if securitized loans are soundly underwritten, those investments should be highly profitable.
One glitch: The bill would let that first 10% of losses be covered by private mortgage insurers, or PMIs. If you are a securitizer but don’t want to hold the 10%, you can offload it to a PMI. And if the PMI fails, the FMIC makes the investors whole, even if losses have not reached 10%. To address that problem, the bill imposes tough capital requirements on PMIs and limits their market share. So while they will be smaller and better capitalized than Fannie and Freddie, the GSE model remains: For-profit companies reap the benefits of government subsidies but can put losses on the government if they fail. This PMI backing should be dropped.
To their credit, Corker and Warner seem determined to stand up to the industry and keep the 10% cushion of taxpayer protection. With a few tweaks, the Corker-Warner bill could provide a reasonable replacement for Fannie and Freddie. But the time to act is now, before Congress gets amnesia counting all that money Fannie and Freddie are generating. Yes, they are profitable, but that will provide little comfort to taxpayers when the next housing downturn hits. And it will.
Coins2Day contributor Sheila Bair is former chair of the FDIC and author of New York Times bestseller Bull by the Horns .
This story is from the November 18, 2013 issue of Coins2Day .
