Moral Hazard: Why Handing Fannie and Freddie to Wall Street is a Lousy Idea

Chew on this, fellow Americans:

Since the government took over Fannie Mae (FNMA) and Freddie Mac (FMCC), taxpayers have spent more than $160 million defending the mortgage finance companies and their former top executives in civil lawsuits accusing them of fraud.

Galling? Sure, although it's standard practice for companies to pick up the legal tab for execs facing such suits. The GSE officials also could have to repay the money if they're found liable. And no doubt some Republican lawmakers and other critics of Fannie and Freddie will seize on the revelations to make their case for privatizing the firms and handing the government mortgage market to Wall Street.

Greasing the skids for a Wall Street takeover
Such a plan is already in the works. Rep. Jeb Hensarling (R-Texas) is pushing a bill that would phase out the GSEs within five years. Under this scenario, big banks would take over the business of buying and securitizing mortgages, but the government would likely continue guaranteeing the loans.

That would be the worst of all possible worlds -- Wall Street firms earning billions of dollars from issuing mortgages backed by the full faith and credit of American taxpayers. Sound familiar? Notes TheAtlantic.com's Daniel Indiviglio:

It would put us right back where we were during the crash. Fannie and Freddie failed because you had publicly traded, profit-seeking firms issuing a government guarantee to price mortgages. In the framework banks propose, you would have precisely the same situation, but with different players. Instead of Fannie and Freddie, you would have big publicly-traded, profit seeking banks issuing a government guarantee to price mortgages. The names change, but the moral hazard stays the same.

The blame game over the housing crash
The subtext in this debate is the need to understand which side -- banks or government -- is chiefly to blame for the housing crash. That's not merely of historical interest. Identifying the roots of the subprime meltdown will guide the creation of public policy to avert future collapses.

Fortunately, the evidence here is conclusive. Although Fannie and Freddie execs, motivated in part by the promise of giant financial bonuses, exacerbated the later stages of the crisis by lowering their underwriting standards, they arrived on the subprime scene well after Wall Street. Michael Hudson, a staff writer with the nonpartisan Center for Public Integrity, notes that the GSEs' share of the market for new mortgages plummeted between 2003-06, just as Wall Street was revving up its production of subprime loans. Another telling stat: As of last fall, only 2.2 percent of GSE-backed loans were in foreclosure, compared to 13 percent of all subprime mortgages.

Public anger at the GSEs is warranted, and reform of the agencies is essential. But the answer isn't to reward the financial firms who created the mortgage mess by handing them the keys to a $10 trillion market. Given the importance of the housing sector to the U.S. (and global) economy, government must -- and will -- have a role. Ideally, that will involve setting up a nonprofit federal agency that fulfills its mission of helping moderate-income people buy homes, while ensuring that the resulting loans and securities don't end up on the taxpayers' tab.

Related:

• Reign of Terror: How Subprime Lenders and Wall Street Caused the Financial Crisis
• Smoking Loans Prove Wall Street Committed Fraud
• Three's Company: How Fannie, Freddie and the Feds Stoked the Housing Bubble
• Fannie Mae: Mugged by Reality, Americans Rethink Homeownership
• Collapse of Fannie Mae, Freddie Mac was Self-Inflicted