Is Obama’s Plan to Replace Fannie and Freddie Feasible?

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Walking away from Fannie and Freddie is hard to do (Kevin Lamarque/REUTERS)

UPDATED Friday 1:36 PM.

First of all, let’s start with what’s clear: The government is not going to exit the housing market. Yes, after the White House’s GSE reform, Uncle Sam may play a more limited role, but that might take as long as 7 years for that transition. Mortgages are likely to become more expensive, but probably not by much.

What’s not clear: What exactly will replace Fannie Mae and Freddie Mac? What the impact on housing prices will be? And, most importantly, is Obama’s plan any better than what we have now?

On Friday, in a widely anticipated joint report from the Treasury Department and Department of Housing and Urban Development, the White House made clear that Fannie Mae and Freddie Mac, the large government mortgage guarantors, which many have in part blamed for the financial crisis – and have become one of the most costly parts of the clean up – are going to disappear. Although in a call with reporters, Secretary Tim Geithner said that path way from Fannie and Freddie would take 5 to 7 years. And would be completed in three steps, frankly all of which kind of sounded the same – so really one long step away.

While the report laid out three possible solutions for what could replace Fannie and Freddie. It seemed clear that President Obama and his advisers preferred what they called option No. 3.  The question is how much would that solution actually limit the government’s losses if we were to have another housing bust.

Under option 3, Obama is proposing to replace Fannie and Freddie with private companies that would provide mortgage insurance. Those companies would then be forced to buy reinsurance from the government for all of the mortgages they guarantee. But the government’s reinsurance would not pay out if a particular mortgage goes bust isn’t repaid. The reinsurance the government provides would only kick in if the private companies are wiped out.

How is this different from the current system? The only real difference is the fee, or what the government will charge these new entities for reinsurance. Fannie and Freddie provided mortgage insurance with an implicit backing from the government. Like these new proposed private companies, Fannie and Freddie had shareholders who were all but wiped when the government in late 2008 ended up taking over the companies. So in that sense it is the same structure. The difference is that Fannie and Freddie never had to pay anything to the government for that backstop. Think of it as we would be essentially flipping the mortgage market into a system that is more similar to what we have with the FDIC and deposit insurance.

So is that any better? I got a range of answers today. But even some typical critics of the administration kind of liked the plan. Josh Rosner, who heads research firm Graham Fisher and is a respected bank analyst, said this was just reshuffling the deck chairs. The government would still be on the hook when something goes bad. And there would still be the dangerous price distortions (too cheap mortgages) that lead to speculation and the bubble. Joseph Mason, a professor of finance at Lousiana State University, who has long studied the government’s role in the finance sector, was more optimistic that the plan by removing the government one step – as a reinsurer – would limit the government’s influence on the market and Uncle Sam’s exposure to loses. Especially since, as Mason thinks, the government might be able to sell off some this insurance risk in the market.

Even Alex Pollock of the American Enterprise Institute, which has usually been fiercely critical of Obama’s plans, said the reinsurance scheme was far superior to what we had under Fannie and Freddie, though Pollock said he would have still preferred to see a complete government pull back from the housing market. The rub is the reinsurance. Here’s where we get to the feasibility. The reason why the plan would have fewer losses for the government than what we had under Fannie and Freddie is that Uncle Sam would have this pool of money that it built up by charging for the reinsurance. Price that right, and there would be money to pay for clean up when things go wrong. Price it wrong and taxpayers are on the hook. Pollock says the government’s history of being able to price insurance is very bad. The problem is there is will be incentive to price it to low, so you can help people get more affordable housing.

So how good is this plan? It is at least a better option then what we have now. If the FDIC is the model as it appears to be, then FDIC did a much better job of managing the banking crisis than Fannie and Freddie did. The FDIC is essentially broke, but it hasn’t required anything close to the $151 billion bailout that Fannie and Freddie have gotten from the government. But the idea that government can have a role in housing and not have it cost taxpayers something in bad times is silly.

UPDATE:  The press person in the Treasury Department called to make it clear that senior Treasury officials had no official preference among the three choices they laid out. It was my reading of the document that led to my conclusion that there was a preference for option 3. For what it’s worth, others have come to the same conclusion.

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