Fannie Mae and Freddie Mac are the dominant companies in U.S. housing finance, which is the biggest credit market after government debt. They are huge, with combined assets totaling $7.8 trillion.
Fannie and Freddie used to be government-sponsored enterprises. This privileged status led both of them to great financial success, combined with formidable political clout. Fannie, in particular, was a notable Washington bully.
But having taken on excessive credit risk in the great housing bubble, they both failed in 2008, were put into and remain in government conservatorship, meaning total government control, and were bailed out by $190 billion in stock purchases by the U.S. Treasury, which means the government became and remains their dominant equity investor.
So, Fannie and Freddie are no longer government-sponsored enterprises and have not been since 2008. Now, they are instead government-owned and government-controlled entities.
Former Rep J.J. Pickle (D-Texas) perfectly summed up the essence of Fannie and Freddie, and the key concept of a government-sponsored entity, a generation ago: “The risk is 99 percent public and the profit is 100 percent private.”
This government-sponsored enterprise combination is economically undesirable but highly tempting to politicians and highly attractive to the investors whose profits expand from receiving the government subsidy involved.
This handsome subsidy is cleverly achieved by creating a corporation with private shareholders who get the profit, but which also has a guarantee of its obligations provided for free by the U.S. Treasury, and therefore by the taxpayers.
When things go well, the huge value of using the government’s credit flows through to the shareholders, while the Treasury and the taxpayers are stuck with the risk and the cost of any failure. What an investment opportunity!
So it is no surprise that some large investors are trying to get Fannie and Freddie made back into government-sponsored enterprises, the stock of which these investors could own, thus reaping billions per year from subsidies created by the government guarantee.
The Trump administration has expressed support for this investment idea, and the president himself has supported the government guarantee involved. There has been a related run-up in the price of the portion of Fannie and Freddie equity still in private hands.
Of course, those who want to bring back Fannie and Freddie as government-sponsored enterprises have to address a tricky element of the guarantee from the government, because they need it to be real and fully believed in by the global purchasers of their mortgage-backed securities and debt.
But at the same time, the Treasury needs to keep Fannie and Freddie off the government’s books by pretending it isn’t really a guarantee. Can they achieve both?
A solution to this conundrum was found in 1968, when the Johnson administration, faced with rising deficits and debt from the rapid expansion of both war and welfare, wanted to get Fannie off its books, while at the same time expanding mortgage credit.
Its solution was to make Fannie’s stock owned by private investors, but to provide government support that the market would accept as a guarantee, without issuing a formal guarantee. In the words of a memorandum of that time, held today in the Lyndon B. Johnson Library, this would “constitute indirect — but explicitly, not direct — Federal guarantees.”
With this idea, it turned Fannie into a government-sponsored enterprise. Then Freddie was created in 1970.
So, “explicitly not direct” was the resulting guarantee that Fannie and Freddie were required by statute to include in each of their offering memoranda that “securities, together with interest thereon, are not guaranteed by the United States and do not constitute a debt or obligation of the United States.”
That seems clear, but nobody at all believed it, and because nobody believed it, the Johnson administration’s scheme worked.
Fannie and later Freddie and their debt were kept off budget while they mightily expanded until their 2008 collapse. At that point, the reality of the guarantee was decisively demonstrated by the complete protection of all creditors of the insolvent companies, even subordinated debt holders.
What now? The worst case would be to turn Fannie and Freddie back into government-sponsored enterprises again, with a free government guarantee to subsidize the investors.
Theoretically, a good outcome would be to return to private ownership, but also require Fannie and Freddie to pay a fair market price for their government guarantee. Unfortunately, as Ed Pinto and I have shown, the fair price for the guarantee is so high that the stock becomes unattractive to investors.
Fannie and Freddie are far too big to fail, so the government cannot get out of its “implicit” guarantee. It looks like the best case at this point is to leave them as government-owned and government-controlled entities, while steadily working to shrink their distorting impact on housing markets, their risk to taxpayers and the inflation of house prices they cause.
Alex J. Pollock is a senior fellow at the Mises Institute and author of "Finance and Philosophy — Why We're Always Surprised" and co-author of "Surprised Again!"
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