Privatization May Not Cure GSE Ills
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- Kirk Haverkamp | December 24, 2010
Fully privatizing the secondary mortgage market might not protect taxpayers from having to once again underwrite major losses in the mortgage market, the Congressional Budget Office (CBO) has warned.
In a new analysis of the role of the federal government in the mortgage market, the CBO determined that eliminating Fannie Mae and Freddie Mac might not get rid of the major problems commonly associated with the two government supported enterprises (GSEs). In particular, it said the “moral hazard” associated with the government’s implicit guarantee of Fannie and Freddie loans might be extended to a fully private secondary market if it were regarded as too critical to be allowed to fail.
Even a perception among investors of an implicit government guarantee of a private secondary mortgage market, owing to its crucial role in the economy, might weaken fiscal discipline and encourage risky lending practices. On the other hand, the failure of the federal government to step in during a financial crisis could cause mortgage funding to dry up entirely.
The report also notes that taxpayers could still be on the hook for private lender mortgage losses if credit risks were shifted to banks covered by federal deposit insurance.
Might allocate risk more effectively
The CBO study looks at three options for winding down Fannie Mae and Freddie Mac and replacing them with secondary mortgage markets with varying levels of federal involvement. It notes that a fully privatized system would present certain advantages, including reducing the reliance of mortgage markets on the viability of individual firms and that private markets may better allocate risk and be more innovative than a secondary market with federal involvement.
It also notes that while private secondary markets might encourage more prudent lending standards, the massive losses suffered on private-label subprime mortgages in the recent fiscal crisis suggest they can also be susceptible to excessive risk.
Pluses, minuses of a federalized system
On the other hand, the study said a fully federalized agency to replace Fannie and Freddie would provide a steady flow of capital in good economic times and bad, but would also give the government permanent control of a large section of the mortgage market, possibly artificially directing economic activity into housing and away from more productive areas.
A fully federalized secondary market might also offer fewer innovations and take on more financial risk, eventually borne by taxpayers, than a private system might, the report said.
A third option would be a hybrid public-private model where the government would provide explicit loan guarantees and private enterprises would provide innovation, control risk and bear initial losses. However, balancing the roles of the government and private enterprises would be difficult, the report said, and such a system might not ensure that the cost is not eventually borne by taxpayers.
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