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A Times Editorial

Tighten reins on Fannie and Freddie

The Federal Reserve and the Treasury Department had no realistic choice but to take steps to shore up the mortgage giants Fannie Mae and Freddie Mac. These companies now make well over half of the country's housing loans. Had they foundered, it could have had a disastrous ripple effect on the economy as a whole.

The plan includes lending the two companies what they need to maintain liquidity at an interest rate that commercial banks enjoy. Treasury Secretary Henry Paulson is also seeking authority from Congress to provide the companies additional credit lines and to buy shares of Fannie and Freddie, if necessary. Congress is expected to act on this request as soon as this week or next.

But the bailout of these "government-sponsored enterprises" transfers risk exposure to the taxpayer in a way that makes us uncomfortable. We are now helping companies that, when profitable, enrich investors and executives. Yet when things turn sour, taxpayers are on the hook. This is the very definition of a moral hazard — a situation that undermines market discipline.

The two home-loan behemoths were created by the federal government in the 1930s to keep mortgages flowing. Their charge was to buy mortgages issued by banks in an effort to free up funds for more lending. Fannie and Freddie's special status has meant there is an implicit understanding that the federal government would act as a safety net if the companies couldn't meet their obligations. This has allowed them to borrow money more cheaply, among other perks.

But this special relationship also allowed Fannie and Freddie, through lobbying and campaign contributions, to persuade Congress to reduce regulation and oversight. While Fannie and Freddie have not been buying subprime mortgages, they have been seriously undercapitalized relative to their financial risks. That has made them more vulnerable during this shock in the housing sector.

For years regulators and some members of Congress have been warning that these companies have not been holding sufficient capital to cushion against potential losses. By pushing to grow despite the lack of corresponding capital holdings, Fannie and Freddie's top executives were rewarded with rich paydays. And they were able to get regulators off their backs by tapping their friends in Congress.

The rescue plan offered by Paulson contains some strings, including giving the Fed a consultative role in setting capital requirements. The government rescue plan would increase the $2.5-billion line of credit each company already has with the Treasury for 18 months. If their private capital dries up, the plan calls for the government to buy stock in the companies, with taxpayers becoming the shareholders. There will be a new regulator for the companies and tighter controls. We'd also like to see a change in the way top Fannie and Freddie executives are compensated to eliminate incentives for risky behavior.

Will all of this be enough? If all else fails, the government should reserve the right to take over the companies. Fannie and Freddie may still be necessary, especially now when so many other mortgage lenders have retrenched, but they need substantially better oversight to make them more responsible. They cannot be allowed to go back to business as usual when this crisis passes. After all, they're playing with taxpayer money.

Tighten reins on Fannie and Freddie 07/15/08 [Last modified: Friday, July 18, 2008 10:41am]
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