Mortgagers' Dual Roles Clash

Richard Syron, the blunt chief executive of mortgage giant Freddie Mac, often refers to his company and its bigger sibling, Fannie Mae, as "odd ducks." That's for sure. Freddie and Fannie are ungainly hybrids. They are part shareholder-owned profit-making companies, part government agencies with a mission to make mortgages cheaper and more widely available. WSJ's David Wessel parses Congress' effort to regulate mortgage companies Fannie Mae and Freddie Mac. At the heart of the debate, he says, is the companies' duel personalities as both public agency and private company. And they are huge -- much bigger than Bear Stearns, the investment bank whose collapse, we were told, threatened the entire financial system. The housing bust is heightening the tension between the two parts of the hybrid. Falling house prices and rising delinquencies weaken the companies financially, raising concerns about their stability and the risks they pose to taxpayers. After all, their entire business is housing. But the past year also underscores the societal importance of their mission -- making home ownership more affordable for lower- and middle-class families and rescuing the economy when housing goes bust. The basic deal has been this: Fannie and Freddie make big profits for shareholders and pay high salaries. Shareholders benefit because Fannie and Freddie borrow more heavily than other financial companies and more cheaply, because everyone who lends them money assumes -- correctly -- that the U.S. government stands behind their debt. (Based on recent public filings, Freddie Mac and Fannie Mae have a debt-to-equity ratio -- a measure of how leveraged they are -- of 27.6 and 19.6, respectively. By contrast, the ratio at Bank of America and J.P. Morgan Chase is about 3.9.) In exchange for their borrowing advantages, Fannie and Freddie and their shareholders agree to promote affordable housing -- even when it isn't a great business -- to be in the mortgage market when no one else wants to be, and to submit to regulation. "We're trapped between these two worlds. It's a good general caution about this fascination with public-private partnerships: The private sector gets rich and the public sector gets something, but the something may not be worth the government subsidy," says Douglas Elmendorf, a Brookings Institution economist. Today's circumstances illustrate the awkwardness. The government essentially is telling Fannie and Freddie: You did well when times were good. Now you have to do some things (lend more, tolerate delinquencies, raise capital at unfavorable prices) for the good of the economy, even if you don't believe they are in the interest of shareholders. Over the past several years, attacks on Fannie and Freddie came in two forms. One was that markets had evolved so much that Fannie and Freddie weren't needed, that others would turn mortgages into securities with government backing. That argument has been demolished. The mortgage market might not be functioning today without Fannie and Freddie or some facsimile. DISCUSSION The other was that the risk Fannie and Freddie -- and thus taxpayers -- take is that interest rates will turn against them, creating a devastating mismatch between the rates they pay to borrow and the rates they receive on their huge portfolios of mortgages. That was before the previously unimaginable happened: a widespread decline in house prices. Fannie and Freddie already have absorbed huge losses, not only on the mortgage-linked securities they hold but also on the $4 trillion in guarantees they have made on principal and interest on mortgages turned into securities held by others. They face bigger losses if house prices fall an additional 10% or 15%, as is widely predicted. For now, turning Fannie and Freddie into completely private, unregulated companies and eliminating the implicit government guarantee, as some have proposed, is impossible. They are so big, so vital, that markets won't believe the government would let them fail. At the other extreme, the government could do away with this faux capitalism. As Lawrence Summers put it when he was battling Fannie and Freddie as Treasury secretary: The Asian financial crisis demonstrated the problems created by the combination of leverage, government guarantees and crony capitalism. (The spotlight on former Fannie Mae Chairman James Johnson's mortgages from Countrywide Financial highlight the third.) So the government could buy out shareholders, convert Fannie and Freddie into government entities that might borrow even more cheaply than they can today, try to maintain incentives for innovation and efficiency, and seek ways to protect them from politicians who want to use them to direct credit. Privatization and nationalization are conceptually pure and politically improbable. Today, half of Congress wants Fannie and Freddie to pick up the pieces from the subprime debacle and lend more; the other half wants to block them from exposing taxpayers to additional risks. So, with pressure from Treasury, Congress is debating the terms of a third option, which Mr. Elmendorf and his Brookings colleagues Martin Baily and Robert Litan describe in a recent essay ("The Great Credit Squeeze4") as permitting Fannie and Freddie "to operate under a set of rules that allows them to be profitable, but doesn't allow them to profiteer at the expense of taxpayers." The tough challenge is to find the right balance, given that Fannie and Freddie exist, have a vital role in protecting the economy from a housing-driven depression, have shareholders with rights to profit and property, and are putting the taxpayers at risk. Too much or too tough regulation will make them unattractive to shareholders at a time when they need to attract capital. Too little or too loose will leave taxpayers overexposed.