A first step for Fannie and Freddie

(breakingviews.com) -- Fannie Mae and Freddie Mac shouldn't be allowed to languish in Uncle Sam's arms. But as the anniversary of their seizure by the government approaches, the $5.4 trillion mortgage giants remain the biggest black holes in the financial firmament.

Lawmakers seem content to allow the two companies to slowly expand. That's a shame -- forcing them to wind down their portfolios of mortgage-backed securities (MBS) would be a good first step toward eventually deflating them.

The Obama administration won't release its recommendations for the companies until February. This gives it time to wage battles in areas ranging from climate change to healthcare. These issues are already drawing heavily on the president's political capital.

That may leave little appetite to tackle the government sponsored enterprises (GSEs), especially given their popularity among some lawmakers and their increasingly dominant role in the mortgage market. The United States has already committed up to $400 billion to cover the firms' losses, providing enough of a cushion to tempt politicians to let the issue slide.

The problem arises from the companies' dual roles. They have a public policy mandate to boost lending to the housing market. And they are supposed to reward shareholders. The conflict between these two goals caused the companies to nearly collapse.

The GSE's principal business of guaranteeing mortgages caused economic distortions that helped fuel the housing boom. As private mortgage lenders pulled in their horns, the GSEs' share of the market grew from under 50% to around 80% by the end of last year, despite the fact that their aggregate portfolios have only increased by about 3% since their conservatorship.

Their success is the sticking point. Society benefits from the efficiency and lower costs derived from the standardization of mortgage pools, which allows them to be easily securitized. The GSEs scale this advantage up significantly. Fannie (FNM, Fortune 500) alone has $2.8 trillion of guarantees on MBS.

On the other hand, the guarantees have unintended consequences. Since investors always reckoned the government stood behind the GSEs, mortgage rates fell below appropriate risk-adjusted market rates. This acted as a subsidy for home buyers at the expense of other taxpayers and contributed to the housing bubble.

Solving this problem without throwing the mortgage market into disarray will be difficult. Winding the GSEs down, or splitting them into smaller firms without government backing would get rid of the subsidy, but could reduce the benefits they brings to the MBS market. In any case, this would be a difficult sell politically due to the firms' dominant positions. Fannie guaranteed more than half the mortgages for new single-family homes in the second quarter.

Policymakers aren't helpless. They can initially target the GSE's portfolios of MBS. Fannie alone holds more than $800 billion worth. The figure has grown at an annualized rate of 6% in the year to date.

The MBS holdings are an arbitrage that benefited the GSEs' shareholders at the expense of taxpayers. Their quasi-governmental status means they could borrow more cheaply than others and plow the money into higher-yielding MBS. The resulting profits went to shareholders.

Moreover, the GSEs successfully lobbied to be able to hold low levels of capital against their investments, boosting returns. This also gave them little margin for error. Since the government now runs the show, there's little reason these holdings can't be wound down, although this would have to be done gradually.

True, the GSEs can act as mortgage buyers of last resort during crises, when the mortgage markets would otherwise seize. Yet Fannie didn't significantly shrink its portfolio of MBS during the easy money years between 2002 and mid-2007. Also, their purchases -- as distinct from their guarantees -- during this period probably didn't have much of an effect on mortgage rates, since they represented a relatively small part of the overall market.

Moreover, when housing markets crashed, the direct mortgage portfolios left Fannie and Freddie (FRE, Fortune 500) saddled with avoidable losses. These are now taxpayer's problem. A quick way to avoid exacerbating this privatization of gains and socialization of losses would be to ban the GSEs from buying more MBS and force them to run off their portfolios. Then the government can turn to the more nettlesome issue of their guarantees.