As the old adage goes, the road to hell is paved with good intentions. This point is illustrated vividly by examining the problems leading to the current housing crisis. Two companies, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae and Freddie Mac, are major contributors to the current economic crisis. Both companies are government sponsored enterprises (GSE) created by the United States Congress to aid with the flow of credit and provide stability and transparency to the housing industry. These noble dreams turned into a nightmarish reality as the United States government passed the $150 billion mark to keep these well intentioned companies afloat. Unlike the bailouts sent to private industry in Wall Street, the money needed to support Fannie and Freddie show no signs of slowing down with projected taxpayer dollars exceeding $350 billion just to keep these market giants from collapsing. There is still no guarantee this enormous amount of taxpayer money will ever be repaid.
The push for higher earnings over the last fifteen to twenty years led to a dangerous expansion of the borrower pool and lowering of established security risk protocol. These two corporations continued to rapidly grow and ignore all of the warning signs. The warnings about the coming train-wreck are well documented. Even during the Clinton administration, Treasury Secretary Larry Summers and Treasury Official Gary Gensler were speaking out about the signs of significant risk in the portfolios of Fannie and Freddie.
During the Bush Administration, White House aides and Treasury Department staffers continued to sound the alarm about the growing risks and moral hazard behind the decisions of these two giants. Moral hazard occurs when a party in a business situation makes a decision about risk, while another party shoulders the responsibility if things go wrong. Moral hazard essentially divorces the decision maker from the ramifications of a poor decision.
With taxpayer money as a backstop, Fannie and Freddie laughed off reform efforts as unnecessary. Even Fed Chairman Alan Greenspan continually warned about the highly leveraged condition of the two corporations which dominated the housing market. These institutions held less capital in reserve in relation to their assets than other corporations of similar size. Any misjudgment or unforeseen circumstance would burn through the reserves and bring down the house of cards. The house of cards started to crumble in 2007 as individuals unable to pay their mortgages spiked leading to rapid rise in home foreclosures and financial institutions holding massive amounts for bad assets. By the time the dominos started to fall, Freddie and Fannie together guaranteed one half the mortgage debts in the United States.
Even two years after the housing meltdown, legislators debate the role and necessity of Fannie Mae and Freddie Mac. Support is still strong for these unnecessary housing programs and no meaningful reform legislation has been approved by Congress, even as Fannie and Freddie continue to drain billions in capital into a financial abyss. This embrace of an outdated program requires reexamination and Fannie and Freddie should realize they have outlived their usefulness and need to be gradually eliminated and not reformed or rejuvenated. Sadly, with no reform proposals on the table, the threat of future moral hazard and indiscretion still looms large in the housing market.
Decades ago, the private sector may not have been properly equipped to provide the liquidity, transparency and stability required by the housing market. However, the housing markets are now tooled to shoulder these roles in the modern marketplace, therefore eliminating the need for Fannie Mae and Freddie Mac.
The worst action is to do nothing. These two GSEs need to be drastically scaled back and capped at a minimum or even better, eliminated. The United States just cannot continue to subject taxpayers to hundreds of billions of dollars in risk. The cost is too high and even with the best of intentions; you still need to measure the results. As the National Crisis Inquiry Commission reported, $11 trillion in wealth vanished in life savings and retirement and the root cause was the failure to stem the tide of toxic mortgages which could have been done with prudent standards of credit.