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Private companies — but they're not — except when they are

July 23, 2008 |  4:09 pm

Got that? The New Yorker's James Surowiecki explains the riddle of contradictions that is the relationship between troubled mortgage-backing giants Fannie Mae and Freddie Mac, the federal government (and therefore taxpayers) and millions of home-loan borrowers in the U.S.

Surowiecki's conclusion? A contradiction, of course. Pardon the long-ish excerpts, but wrapping your head around the Fannie and Freddie maladies takes some reading. First, the details and problems:

Fannie and Freddie are the duck-billed platypuses of the financial world. They’re profit-driven corporations, owned by shareholders and, in theory, beholden only to them. But they’re also so-called “government-sponsored enterprises,” set up by the state with the explicit mission of fostering homeownership, by buying and selling home mortgages. Unlike ordinary corporations, they’re exempt from most state and local taxes and certain S.E.C. requirements, and they have access to a government credit line....

The G.S.E.s are curious, because there’s no obvious reason for them to exist in the form they do: instead of creating private companies to do all these jobs, the government could just do them itself. In fact, that’s how Fannie Mae got started, back in 1938: originally, it was a government agency endowed with the authority to buy mortgages, in the hope that this would expand the supply of credit to homeowners. It wasn’t until 1968 that Fannie was privatized. (Freddie Mac was created two years later, and was private from the start.) ....

Making Fannie and Freddie into these weird hybrids may have spruced up the budget, but in the long run it also made it easy for the companies to grow too big, too fast. Because everyone assumed that the government would make good on Fannie’s and Freddie’s debts, they could borrow money more cheaply than their competitors. They used this cheap debt to increase the number of mortgages they bought. Had Fannie and Freddie been ordinary private companies, there would have been a natural check: companies with more debt are usually seen as riskier, and that makes shareholders and bondholders less willing to invest in them.

And, Surowiecki's solution:

Whatever their sins, Fannie and Freddie clearly couldn’t be allowed to fail, but that’s no argument for letting them go on as they are. Either they should be forced to make it as private companies or they should be nationalized. Given that their business depends on the promise of government assistance and that their current state remains woeful (despite an upturn in their fortunes late last week), nationalization seems more sensible. If Fannie and Freddie are going to run up a tab and stick taxpayers with the bill, why should shareholders profit?

I suppose Surowiecki doesn't have much wriggle room here. Even if the idea of federally chartered mortgage-backing companies is a bad one, Fannie and Freddie have existed long enough to crucially entrench themselves in the mortgage market without many regulators in Washington paying attention. In other words, the feds and Fannie and Freddie have made their own bed (the companies having grown too large thanks to their special status) and now we all have to sleep in it (via bailouts). Privatization or nationalization — either way, taxpayers would be on the hook for unholy amounts of cash. Both companies back or own around $5 trillion in mortgages combined; their failure would do far more than exacerbate our current economic malaise.

And here's where Surowiecki injects his fitting contradiction by asking the trillion-dollar question: What if Fannie and Freddie were allowed to fail? His answer: maybe we should see. Read more after the jump.

Here's Surowiecki's Fannie and Freddie denouement:

Beyond that question, though, is a more important one: Do we need Fannie and Freddie at all? Their supposed reason for being is that their ability to borrow money at low rates lowers borrowing costs for homeowners. But a paper by the economist Wayne Passmore, of the Federal Reserve, suggests that in fact Fannie and Freddie have only a small effect on the interest rates that homeowners pay, saving them less than one-tenth of a percentage point.... The government already offers homeowners a subsidy, in the form of a mortgage tax break. Given everything else we could be spending taxpayer money on, does the government really need to be in the mortgage-buying business, too? 

One-tenth of an interest point? That number drives home a key point: The $5 trillion figure may inspire a do-something reaction, but the real impact of a world without Fannie and Freddie could be pretty easily absorbed by individual homeowners. Even without the mortgage backers, the federal government would still be in the business of favoring house-dwellers with the mortgage interest deduction on income tax returns.

Anyhow, the real reason for the post is to get you, dear Opinion L.A. readers, to check latimes.com/opinion tomorrow for the Thursday installment of this week's Dust-Up, in which Doug Henwood and Steven E. Landsburg will tussle over the question, "Why shouldn't Fannie Mae and Freddie Mac (and other large lenders) be allowed to fail?" Here's a preview from lead batter Henwood:

Why not let Freddie Mac go down, with IndyMac right behind? I gotta say, it's really tempting to say, sure, let 'er rip. For decades, we've been listening to laissez-faire types preaching about the beauties of the market's system of rewards and punishment.

Check back tomorrow for the rest of Henwood's answer and Landsburg's counterpoint.

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