Statement on the Conservatorship of Fannie Mae and Freddie Mac

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By Dean Baker

Secretary Paulson’s decision to put Fannie Mae and Freddie Mac under a conservatorship was the right move at the right time. As the market reaction shows, it removed an important source of uncertainty in the housing market and in financial markets more generally. The big question now is what these institutions will look like going forward. There is a strong argument for keeping these institutions public.

First, it is important to be clear on why Fannie Mae and Freddie Mac faced collapse. These mortgage giants went under because they were somehow unable to recognize the housing bubble and to adjust their lending to protect themselves against the inevitable crash. It is their job to know the housing market and to recognize a bubble. Furthermore, if Fannie and Freddie had begun to tighten credit five or six years ago, when house prices were already clearly out of line, they could have stopped the growth of the bubble before it reached such dangerous proportions.

The current disaster should not lead people to forget the benefits that these companies conveyed to homeowners. By creating the secondary-mortgage market, they created first a national and then an international market for home mortgages. This had the effect of equalizing interest rates across the country and making homeownership affordable to millions of families.

There is still a very big need for Fannie and Freddie to ensure a well-operating secondary-mortgage market. However, it is not clear what benefit the country would get by returning them to their mixed public-private status. In effect, both Fannie and Freddie can be operated as public corporations, which was the case with Fannie Mae prior to its privatization in 1968.

The private sector should take the leading role in most areas of the economy because it is more innovative and more willing to take risks than the public sector. However, it is not clear that we want a lot of innovation in the secondary mortgage market. Financial innovations in the mortgage market helped extend the housing bubble and are the basis of much of the financial turmoil now facing the country and the world.

We would have benefited enormously had Fannie and Freddie operated in a conservative manner – buying up mortgages that met solid lending criteria, and packing them into standard mortgage-backed securities. Fannie and Freddie's eagerness to keep market share, even at the cost of acquiring riskier mortgages, was the main cause of their bankruptcy. Their innovative private sector practices are likely to cost taxpayers tens of billions of dollars in this bailout, in addition to the much greater harm they caused to the economy by extending the housing bubble.

In the future, Fannie and Freddie can best serve their role of providing the stable anchor of the secondary mortgage market by being government corporations. These companies are playing with the taxpayers' dollars. While the public guarantee of Fannie and Freddie debt is necessary to ensure the stability of the secondary-mortgage market, there is no reason that this guarantee should apply to any investment on which their top executives choose to gamble.