(This is Part 2 of a two-part series. See Part 1: What is all the fuss about Fannie Mae?)

Last week I indicated that accounting misdeeds by Fannie Mae had stimulated discussion of the controversial role of Fannie and its smaller sister agency, Freddie Mac, in the U.S. housing finance system. John Q Public as borrower benefits from the agencies, which reduce interest rates on the loans they buy by .25 percent to .375 percent. John Q Public as taxpayer, however, will be on the hook if the agencies encounter such serious financial problems down the road that they cannot meet their obligations without government help.

This article is about John Q Public as citizen, who seeks the best possible way to protect taxpayers while minimizing hurt to borrowers. The agencies themselves take the position that nothing need be done because they will keep themselves safe and sound. In contrast, most informed observers outside the agencies opt either for stronger regulatory control or for full privatization.

Stronger Regulatory Control: The argument is that stronger regulatory control could prevent the agencies from getting into the kind of trouble that would require government intervention. This view is supported by OFHEO, the existing regulator, which has struggled to convince the Congress that it is “tough enough” to regulate the agencies. Support for this approach also comes from some industry players, who expect that tighter regulation will include curbs on the agencies’ expansion into new markets where the players don’t want them. Congress also appears favorably disposed to tighter regulation.

The basic problem with the regulatory approach is that it could easily fail, as it did with the savings and loans, which were a regulated industry. One major reason that regulation failed in that case was that the safety and soundness objective of the regulators was undermined by a broad public policy that prevented savings and loans from writing adjustable-rate mortgages. That policy was not changed until after most of the damage had been done.

The current arrangement for regulating Fannie and Freddie has an eerily similar conflict. One regulatory arm is focused on safety and soundness, the other on meeting the mortgage loan needs of the disadvantaged. Maybe this will work, but the history of financial institution regulation suggests that the risk is high that it will not.

Full Privatization: The major argument for full privatization is that a private firm whose debts are neither implicitly nor explicitly guaranteed by the government could fail without taxpayers having to foot the bill.

Further, there is no rationale today for a government-supported but privately owned duopoly. This type of structure harkens back to the beginnings of the country, when every corporation required a special charter from the state that spelled out its privileges and responsibilities in detail. That approach ended with the enactment of general incorporation laws, but here it is again with Fannie Mae and Freddie Mac.

This was a historical accident. Both Fannie and Freddie began life as government agencies, and the switch to private ownership (while retaining government support) was designed to encourage development of a private secondary mortgage market. That was a reasonable rationale at the time, but no longer because the objective has long since been achieved.

Many firms are active today in purchasing mortgages that are not eligible for sale to Fannie and Freddie, but theirs is a small part of the total market. The larger part belongs to the agencies, which are safe from the competition of firms that don’t enjoy their privileges.

The Transition: The challenge is to remove government support without hurting investors who have relied on that support. We also want to avoid damaging the agencies because after full privatization, they will be obliged to compete with other private firms.

My proposal is to have the government explicitly guarantee all the outstanding obligations of the agencies as of a specified transition date. The credit lines the agencies now have with the Treasury would be revoked on the same date. These actions prevent repercussions in financial markets, yet put markets on notice that new obligations are not guaranteed.

Over time, the volume of guaranteed claims would gradually decline. The existing segmentation of the secondary market into a large piece controlled by the agencies and a small piece with many players would end.

There are good arguments on all sides of the debate about what to do with Fannie and Freddie, but there are no good arguments for the status quo. Those who believe that the government-supported private firm model is a good one should be proposing that we expand their number. I have never heard a reasoned defense of why the privileges of government sponsorship should be limited to two behemoths.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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