Defanging Fannie and Freddie

These private-public hybrids must not be allowed to lobby Congress for unfair perks.

September 9, 2008

The US government takeover of Fannie Mae and Freddie Mac has lifted a fog of fear over financial markets and brought a respite of stability. Coming just before an election, it should also spark debate over the future of these two giants – as well as all federal aid to middle-class homeownership.

The debate must start with one basic issue: Why does Congress lose sight of its financial responsibilities after launching an effort to provide a "social good"?

Just as lawmakers still neglect reform of Medicare and Social Security to prevent those debt-ridden programs from bankrupting the nation, they were particularly guilty in allowing Fannie and Freddie, as government-backed enterprises, to recklessly grow too big and take on too much risk in the secondary mortgage market. The two firms helped create a housing bubble by supporting loans to people with weak credit and then became dangerously impaired during the bubble's burst.

Even worse, political corruption set in. Congress let Fannie and Freddie spend millions of dollars on lobbyists to maintain advantages over competitors and to be only loosely regulated. These secretive and powerful institutions pressured the housing industry to lobby on their behalf and provide campaign money to legislators.

One of the conditions put in place in their federal takeover is this welcome move: Suspension of the two firms' political activities.

But watch out. As Congress takes up reform of Fannie and Freddie next year and maybe recreates them with government backing, it may let the lobbying resume. Lawmakers will then benefit again from the industry's largess and forget their watchdog role.

Anyone who thinks of homeownership as a safe investment should be worried about electing lawmakers who take campaign donations from an industry that directly benefits from federal credit support and then builds another housing bubble.

Fannie and Freddie must be reduced to a small role in housing and especially one that solely helps the poorest in America. They should never again command two-thirds of new mortgages up to $730,000 or put taxpayers on the hook for billions if they were to fail.

Many in Congress, however, have already criticized the plan by the Treasury Department to shrink the mortgage holdings of Fannie and Freddie down to a third of their current size by 2010. If anything, the Treasury plan is too timid. But that is a result of trying to reform Fannie and Freddie during a crisis and with a shaky hope that they can still prop up housing prices. (Prices need to fall even further in many markets to achieve a true market correction.)

Congress could get diverted by a debate over the fairness of taxpayers possibly taking a hit if this takeover doesn't go as planned while those who hold preferred shares in Fannie and Freddie walk away with some money. That's a useful debate if it reinforces "moral hazard" for investors and reminds lawmakers that they represent taxpayers first.

But reform must start with rooting out the immorality of incumbent lawmakers having benefited from Fannie and Freddie and neglecting their financial responsibilities in reining in this outsized federal effort that went awry.

If Congress now gets this reform right, maybe it can do the same for Medicare and Social Security.