Scrapping Fannie and Freddie is Only Step One for Our Broken Mortgage System

The news that the Obama administration seeks to “wind down” both Fannie Mae and Freddie Mac has generated positive – albeit cautious – praise from right-of-center thinkers not known for their support of much of the Obama economic agenda. If the Administration is actually serious – which is a fair question – then this is a nice development.

Not only is the existence of both entities constitutionally dubious, but there’s not much evidence supporting the claim that their presence in the mortgage markets actually brings down lending rates. An American Enterprise Institute study put the number at roughly 7 basis points.

Better than that, we as always live in a world of finite capital, so when government-backed entities are able to vacuum up funds to subsidize home ownership, this must by definition depress other sectors of the economy with capital needs that don’t match the government’s ability to raise it. If Fannie and Freddie cease to exist, the markets for credit will be less distorted on the way to a more growth-oriented environment in which the best concepts – as opposed to those most politically connected – will attract investment.

The above aspect concerning capital flows can’t be minimized. Indeed, the seen in this instance is the presumption that Fannie and Freddie have driven up rates of homeownership, but the unseen concerns all the medical, pharmaceutical and technological innovations that never saw the light of day thanks to the federal government’s privileged space in the capital markets.

It’s also the case that there’s no strong evidence that either entity actually drove up rates of ownership. Sure enough, England can claim neither Fannie/Freddie, nor a mortgage interest deduction, yet the rate of homeownership there is slightly higher there compared to the U.S.

Unfortunately, in floating the Fannie/Freddie wind-down proposal, the Obama administration has given the federal government lots of room to re-enter, or remain in the mortgage market. And there lies the problem.

Specifically, the federal government would reserve the right to backstop the mortgage and housing market “during periods of market stress.” If so, the purpose of the government’s happy exit from the housing market would be defeated almost in total.

For one, the stated aim of Fannie and Freddie at present is to make housing more affordable to Americans. Whether that’s right or wrong will continue to be debated, but if there’s housing market stress that actually brings down home prices, it would be more than improper for the federal government to not let home prices fall as much as possible with affordability in mind.

Secondly, what is “market stress” for government bureaucrats, lenders, homebuilders and homeowners is a precious market signal for the broader economy. Far from something that the federal government should blur through intervention, a declining housing market would provide investors with essential information telling them to cease throwing good money after bad.

For the government to enter the markets when they’re in trouble is for that same government to retard economic growth. Housing-market stress would signal overinvestment in the housing sector, and if growth is the goal as it should be, the pain should serve as a flashing sign telling the federal government to let markets run their natural course in order to avoid further capital destruction.

The Obama administration has also noted that while its plan is to once again to wind down Fannie and Freddie, the Federal Housing Administration FHA will remain in place to among other things, provide home loans to low-income individuals. What a shame if so.

Indeed, by virtue of them earning low incomes, it’s essential for the poor to be completely mobile. Capital moves at the speed of light and without regard to where low earners own homes. So for the federal government to subsidize their housing purchases is for government bureaucrats to commit a very cruel act whereby those most in need of mobility are essentially landlocked by the proverbial ball-and-chain that is housing.

And while it’s not the only reason that unemployment remains high at present, one certain factor is that too many Americans bought houses that are presently difficult to sell. Absent government subsidies meant to promote the false God that is homeownership, it’s a fair bet that many of the poorest Americans would be relocating to the parts of the country in which jobs are most plentiful.

So while the Obama administration should be given credit for at least floating the notion of winding down Fannie Mae and Freddie Mac, logic tells us that’s not enough. Housing on its very best day is the consumptive result of strong economic growth as opposed to the driver of same.

In that case, rather than subsidize further capital flows into that which won’t make us more productive, won’t cure heart disease, won’t drive software innovations, and that won’t open up foreign markets, it’s essential that Washington get out of the housing business altogether. Doing so will free up capital from sub-optimal uses, and that capital will find its way to innovative economic concepts that if allowed to grow will paradoxically ensure a more thriving and plentiful housing market.

A sound housing market is not that which makes us rich, rather we’ve historically had a healthy housing market because we’re rich.  The distinction is important.

The trick here is to not put the cart before the horse. Housing vitality is decidedly not the driver of real economic activity; rather it’s the certain beneficiary of it. After that it’s essential not just to abolish Fannie Mae and Freddie Mac, but all government housing supports that landlock those most in need of mobility, and that naturally depress other, less favored sectors of the economy.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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