It’s a debate that could rage for years: were Fannie Mae and Freddie Mac catalysts for the housing meltdown and financial crisis, or victims of a boom-bust cycle they couldn’t have foreseen?

The prevailing views on the topic could help decide whether Fannie and Freddie — placed into government conservatorship in September — will be rehabilitated or allowed to go the way of the dinosaur.

Republican presidential candidate Sen. John McCain is among those who see Fannie and Freddie as catalysts — "the match that started this forest fire."

Editor’s note: Fannie Mae and Freddie Mac have played a vital role in the function of the mortgage market. Their future is now the subject of congressional debate, as this article details. Inman News has launched an editorial project, the Roadmap to Recovery, that focuses on the path that will lead the economy and housing market out of this crisis. Click here to find out more and to participate in this project.

It’s a debate that could rage for years: Were Fannie Mae and Freddie Mac catalysts for the housing meltdown and financial crisis, or victims of a boom-bust cycle they couldn’t have foreseen?

The prevailing views on the topic could help decide whether Fannie and Freddie — placed into government conservatorship in September — will be rehabilitated or allowed to go the way of the dinosaur.

Republican presidential candidate Sen. John McCain is among those who see Fannie and Freddie as catalysts — "the match that started this forest fire."

Rep. Henry Waxman, D-Calif., insists the public-private companies were simply following the market, not leading it. Fannie and Freddie’s executives "made reckless bets" that led to the downfall of their companies, Waxman says, but it’s "a myth to say they were the originators of the subprime crisis."

Waxman’s Committee on Oversight and Government Reform held a lengthy hearing Tuesday intended to examine not only the extent to which Fannie and Freddie Mac may have contributed to the housing crisis, but what to do with the companies now that they are the taxpayer’s problem.

There’s little talk of restoring the companies to their former status as for-profit companies with implicit government backing — an arrangement critics say allowed shareholders to reap profits in good times but left taxpayers footing the bill in bad.

But with the collapse in the market for private-label mortgage-backed securities that don’t carry their guarantees, at the moment Fannie and Freddie are playing a more crucial role than ever in providing liquidity to mortgage lenders.

Fannie and Freddie’s future

The question has become what to do with the companies when some semblance of normalcy returns to mortgage markets and the financial system. Privatize the companies? Have the government take over their role completely? Reform their structure and oversight so they aren’t caught up in a similar mess again?

Columbia Business School professor Charles Calomiris told Waxman’s committee that once the crisis has passed Fannie and Freddie should be fully privatized. Their assets could be sold off or the companies carved up into a larger number of competing businesses with no government guarantees of their debts or liabilities.

If the government wants to provide support for low-income homeownership in good times, it can do so through government programs like Federal Housing Administration loan guarantees, Calomiris says. Or the U.S. could emulate Australia’s policy of providing first-time homeowners with grants to help fund down payments.

But many see Fannie and Freddie as a source of liquidity in tough times, providing a channel for funds to flow into mortgage lending when banks and financial institutions might otherwise be reluctant to lend.

That argument doesn’t carry much weight with Calomiris, because he is among those who see Fannie and Freddie’s practices as a cause of the current crisis rather than a solution. If Fannie and Freddie aren’t around the next time a crisis arises, he maintains, the Federal Reserve and Treasury Department could provide support for the mortgage market — much the way they are doing now.

‘Agents of reform’

Thomas H. Stanton, a fellow of the Center for the Study of American Government at Johns Hopkins University, doesn’t see Fannie and Freddie going away anytime soon. While Stanton doesn’t want to restore Fannie and Freddie to their status as privately owned, government-backed companies, he sees potentially "enormous" benefits in placing the companies into receivership and using them "as agents of reform" for the mortgage market.

The first step, Stanton says, should be to move Fannie and Freddie from government conservatorship into full-blown receivership, removing shareholders from the picture altogether. Until Fannie and Freddie are placed in receivership, the government will face an inherent conflict, he contends.

"Technically, conservatorship means that the government is working to restore the companies to financial health," Stanton said. Shareholders are preserved and stock in the two companies is freely traded. That’s not consistent with the government’s goal of using Fannie and Freddie to support the mortgage market, he said.

"Until shareholders are removed from the equation, officers and directors of the two companies will face conflict as to their fiduciary responsibilities," Stanton frets. "Do they price mortgage purchases low to support the market or do they price higher to replenish the companies’ shareholder value?"

Placing the companies in receivership would allow the government to use Fannie and Freddie to fund mortgages to meet "pressing public purposes" as defined by the Obama administration, Stanton says, and also provide consumer protections for borrowers and impose financial strength and accountability requirements on lenders. Fannie and Freddie’s automated underwriting systems could even be adapted for use by other federal agencies, such as FHA, he said.

By requiring the companies to serve public purposes rather than a mix of public and private objectives, Stanton says, the government could "turn the insolvency of Fannie Mae and Freddie Mac into an opportunity."

After placing Fannie and Freddie in receivership, Stanton envisions a five-year sunset provision on each company’s charter. Once the mortgage crisis has passed, "policymakers can decide whether further support for the mortgage market is required, and the organizational form that is most suitable."

On that topic, Stanton had more to say about how not to organize Fannie and Freddie should Congress wish to keep them around.

When Fannie and Freddie enjoyed the implicit backing of the government, they were able to borrow money more cheaply than their competitors. But as publicly traded for-profit companies, they used that advantage to generate profits for shareholders.

In addition to providing guarantees for mortgage-backed securities, Fannie and Freddie have amassed huge investment portfolios that include billions in securities backed by subprime and alt-A loans, increasing the companies’ risk exposure.

"In short, the drive to satisfy shareholders is intense and easily can overwhelm considerations of what might be best for the financial system or the mortgage market or American taxpayers," Stanton said.

Another potential problem is that Congress, rather than regulators, has had the biggest say in how the companies are run. That authority is exercised by specialized committees instead of "taxpayer-conscious" committees like the House Ways and Means and Senate Finance committees, Stanton said.

When Congress created a new regulator for Fannie and Freddie in 1992, the Office of Federal Housing Enterprises Oversight, "strenuous lobbying" by the companies "assured that the new regulator lacked the authority needed to do its job," Stanton said. After that, the companies were able to block "even modest pieces of regulatory reform legislation" until passage of the Housing and Economic Recovery Act of 2008.

However sound the accountability structure may be when the organization begins, "the incentive to satisfy private owners will lead a (government-sponsored entity) to try to weaken safety and soundness oversight and lower capital standards," Stanton said.

Assigning blame

Stanton, who in a 1991 book examined the potential for Fannie and Freddie to create a financial crisis, believes the companies aren’t to blame for "the mortgage credit debacle." But Fannie and Freddie did "engage in risky practices that turned them into sources of vulnerability rather than strength for the mortgage market and larger economy," he said.

Huge volumes of subprime, alt-A, interest-only, and other toxic mortgages were funded not by Fannie and Freddie but through private securitizations and collateralized debt obligations that "were virtually unregulated except by the vagaries of the rating agencies and exuberance of the market during the housing bubble," Stanton said.

But as the bubble reached its limits and began to deflate, Fannie and Freddie "tried to catch up and regain the market share that they had lost to the new competition," he said.

Calomiris said Fannie and Freddie boosted their support for subprime and alt-A lending at the tail end of the housing boom in order to meet affordable housing goals, and also to retain support in Congress after accounting and management scandals sparked regulators to impose new limits on the companies in 2004. The role that affordable housing goals and the Community Reinvestment Act played in the boom-bust housing cycle was a topic of considerable debate in the November election (see story).

While there’s little debate that Fannie and Freddie face potentially huge losses, many experts see their role in funding alt-A and subprime markets during the boom as a minor one. An analysis of 12 million subprime loans by the Orange County Register concluded that Fannie and Freddie were "bit players," purchasing about 3 percent of all subprime loans issued from 2004-07.

Waxman conceded that the bulk of Fannie and Freddie’s credit losses — nearly $12 billion so far this year — have been the result of their purchases of alt-A loans and securities. But he said it’s a myth to blame government policies promoting homeownership, because loans lacking full-income documentation did not count toward the companies’ affordable housing goals.

Calomiris says the impact Fannie and Freddie had on lending practices went beyond the volume of subprime and alt-A loans they purchased or guaranteed. Because of their prominent and protected place in the market, Fannie and Freddie "could set standards and influence pricing in ways that other lenders could not," Calomiris said.

Risk managers at Freddie Mac were aware of the company’s ability to "make a market" in no-documentation loans, Calomiris said, and the company’s original decision not to support such loans may have had a role in their disappearance in 1990.

An October 2004 memo to Freddie Mac CEO Richard Syron revealed the extent of the internal debate within the company about whether to continue purchasing such loans. The memo revealed that Freddie Mac’s own research — prompted by public debate over the riskiness of the loans — showed "origination practices that raise concerns." Syron was told of a "lack of consistent borrower disclosure" and instances where borrowers were coached to "lose their income information" after failing to qualify for a loan relying on standard documentation.

In the memo, Syron was also informed that the loans — originally intended primarily for self-employed borrowers who had difficulty documenting their income — were increasingly being marketed to salaried or fixed-income borrowers.

"It appears NINA (no-income/no-asset loans) may be targeted to Hispanics," the memo said. "This increases the risk that this product may be associated with predatory lending."

But if Freddie Mac managers wanted to stop buying no-documentation loans, the memo said, "the entire alt-A business is at risk" because the no-documentation loans were bundled into mortgage-backed securities with other, potentially less risky alt-A loans.

In his testimony, Syron said Freddie Mac "did not create the subprime market" but "needed to participate in order to carry out its public mission of promoting affordability, liquidity and stability in housing finance." Had the company not done so, he said, "it could not have remained competitive or even relevant in the residential mortgage market we were designed to serve."

Another internal memo, this one summarizing a meeting of senior Fannie Mae managers in the summer of 2006, outlined a company strategy to "say ‘yes’ to our customers by increasing purchases of subprime and alt-A loans." The memo — marked "confidential — highly restricted" — complained that Fannie Mae’s credit-guaranty pricing remained "too conservative," with safety margins "layered on multiple times."

Calomiris noted that Fannie and Freddie’s entry into the subprime and alt-A markets coincided with the growth of those markets. Total subprime and alt-A originations grew from $395 billion in 2003 to $715 billion in 2004, and $1.01 trillion in 2005. Fannie and Freddie also "stayed in these markets long after the mid-2006 downturn, when many other lenders were exiting," Calomiris said.

Calomiris thinks the crisis now under way in housing and lending would have been less than half as severe without Fannie and Freddie’s "dominant involvement" in the subprime and alt-A markets.

Summing up the views of Stanton and other experts who disagree, Waxman said Fannie and Freddie’s executives made "reckless bets" that "could cost taxpayers hundreds of billions of dollars." But, he said, "it is a myth to say they were the originators of the subprime crisis. Fundamentally, they were following the market, not leading it."

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