Monday, July 28, 2008

Fannie and Freddie Smackdown: The William Poole Edition

William Poole makes it clear how he feels about Fannie and Freddie:
Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon. Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.

There are lots of insurance businesses around: property, auto, life and many others. These markets work fine without any government-sponsored enterprises. They are not highly concentrated into a small number of dominant players whose failure would threaten the entire economy; rather, lots of companies compete and spread the risk. Indeed, there are well-established firms in mortgage insurance, but their growth has been stunted by the special advantages Fannie and Freddie enjoy.


There are more general economic reasons for liquidating Fannie and Freddie, the biggest being that it is very dangerous to maintain such a large role in any market for only two operators. Markets work best when numerous firms compete against each other.

And then there is moral hazard. Knowing they had a federal backstop, Fannie and Freddie held too little capital and the market financed their activities at interest rates very close to those enjoyed by the government. Now we are living through the result. Does it make sense to reconstitute them so that they can engage in a repeat performance?

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