Fannie & Freddie: Parable of Privatization

Privatization, the turning of government assets or functions over to the private sector, has become one of the favorite causes of conservatives during the post-Reagan era. For 30 years, with varying degrees of success, they’ve attempted to change essential federal programs aimed at public betterment into profit-based business opportunities. Whether it’s Amtrak, the US Postal Service, Medicare and Social Security, or the Defense Department, the argument has been that business interests can do the job cheaper and more efficiently.

The idea has resonated, partly because we live in an era of limits. To many, privatization suggests fewer items in the federal budget, a smaller national deficit, and less need for taxes. Of course, it also means being penny-wise and pound-foolish, as the old saying goes. In the end, the tab rises, either in the form of exorbitant government contracts or overcharges to consumers.

Creeping privatization is perhaps worst in the way it’s affected the domestic economy in recent years. Among government agencies, the twin poster children for the innate evils of privatization have to be the housing-finance giants, Fannie Mae and Freddie Mac, whose wayward activities contributed so heavily to the financial crisis of the last decade and the recession that followed.

Fannie and Freddie are what are known as government-sponsored enterprises, or GSEs. The designation means they are federally created corporations with private shareholders that operate for a profit, but that also fulfill an explicit public role — in this case, encouraging homeownership by buying and guaranteeing home mortgages, which are then resold to investors.

At the height of their power and influence on the eve of the financial crisis, Fannie and Freddie — their proper names, respectively, are the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) — owned or guaranteed half of all home mortgages in the US. They were, in other words, too big to fail, despite the fact that many of their mortgages were based on bad loans.

When the collapse came in late 2008, the Treasury first bailed out the two GSEs, along with private banks, at a cost of $200 billion; they were then (Sept. 7, 2008) placed in protective “conservatorship,” a form of temporary nationalization, under the aegis of their regulator, the Federal Finance Housing Agency. The Treasury has since pumped another $140 billion into Fannie and Freddie to maintain their solvency. But this gets us ahead of our story.

Fannie Mae, the older and larger of the two GSEs, began life in 1938 as a New Deal government agency. (Freddie Mac, chartered in 1970, was a GSE from the start.) Fannie’s purpose in Depression-era America was to revive the prostrate housing sector by expanding the supply of loan credit beyond what local banks could provide; it did this by buying bank mortgages from the individual lenders, thereby replenishing their credit reserves and stimulating further lending. Fannie also encouraged and insured long-term (30-year fixed) mortgages as a way of lessening foreclosures. These two government innovations, development of a “secondary market” to expand loan availability and creation of extended mortgages to ease loan repayments, produced the unique phenomenon of broad, democratic homeownership characteristic of the modern American middle class.

So far, so good. Then, the forces of privatization began to intrude. In 1954, the Republican 83rd Congress made Fannie Mae a “mixed-ownership” corporation that included private shareholders. In 1968, Lyndon Johnson completed the job by making the agency a fully privatized, shareholder-owned company, in order to remove its liabilities from the federal balance sheet and disguise the budgetary impact of the Vietnam War.

Under privatization, things gradually deteriorated. In 1970, Freddie Mac was created to provide market competition for the newly privatized Fannie, which was now authorized to expand into conventional (non-FHA and non-VA) mortgages and soon (1981) began to purchase risky adjustable-rate mortgages. Fannie simultaneously started packaging and selling its mortgages to investors in the form of mortgage-backed securities, the precipitating factor in the eventual banking crisis. In 1983, Freddie contributed to the growing and dangerous debt-securitization trend by inventing a financial instrument for speculators called the collateralized mortgage obligation.

Finally, in 1995, both Fannie and Freddie joined with major Wall Street banks to form Mortgage Electronic Registration Systems (MERS), a centralized data clearinghouse and “mortgagee of record” that by-passed normal transactional procedures to facilitate the high-speed computerized trading of mortgage-backed securities; MERS, a creature of dubious legality, is now implicated in multiple lawsuits over the actual ownership of countless foreclosed homes. Further, according to institutional profiler Christopher Ketcham (Harper’s, January 2012), its questionable efficiencies led directly to the mortgage-finance bubble of the 2000s.

All of this was geared to making more money for the stockholders of Fannie and Freddie and thereby bigger bonuses for their executives. In the 1990s, gambling in exotic securities began to replace supporting affordable housing as the focus of the two GSEs. In the process, they became over-leveraged with bad debt.

Corruption crept in as well. Under the leadership of a series of high-flying CEOs (notably, James Johnson and Franklin Raines at Fannie Mae), two formerly impeccable public agencies gradually evolved into reflections of Enron. Not satisfied with annual salaries in the $10-$15 million range, executives cooked their books to manipulate apparent earnings and maximize bonuses.

Once the GSE accounting scandals broke in 2004-05, Fannie and Freddie were living on borrowed time — and so was the US housing industry. The implosion of 2008 should have come as no surprise; yet, it did, because of a misplaced faith that merely changing executive personnel at the tainted GSEs would permit a resumption of profitable business as usual. But the problem was not a few bad actors; it was the entire concept of a completely privatized housing sector responding only to market imperatives.

Under federal conservatorship, basically a variation of Chapter 11 bankruptcy, the presumption is that, once stabilized, Fannie and Freddie will eventually resume their privatized status. That’s a flawed notion. In truth, these GSEs should be moved from conservatorship back to what the original FNMA was under FDR: pure government agencies with a limited social mission, a fixed budget, and modestly paid federal managers. Doing anything else means we’ve learned nothing from the financial crash and its aftermath.

Wayne O’Leary is a writer in Orono, Maine, specializing in political economy. He holds a doctorate in American history.

From The Progressive Populist, May 15, 2012


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