The Fannie Mae and Freddie Mac Rescue Plan

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

September 8, 2008

Editor’s note: Senior Fellow Douglas Elmendorf, whose federal posts have included the Federal Reserve Board, U.S. Treasury Department, Council of Economic Advisors and Congressional Budget Office, offered his views on the federal government’s plan, announced on September 7, to take control of troubled mortgage lenders Fannie Mae and Freddie Mac.

Q: In your view, is the Treasury Department’s action the right approach?

The rescue plan for Fannie Mae and Freddie Mac announced this weekend is mostly very good: The plan keeps the companies’ operations going, which is absolutely necessary for financial and economic stability. The plan does not bail out the existing shareholders but mostly limits the government’s financial investment to the amount needed to bring the enterprises back to positive net worth.

The plan recognizes that we cannot immediately restructure Fannie and Freddie to fix their hybrid public-private nature, but it ensures that the government has full control over the enterprises so that long-run decisions about our system of housing finance can be made in the best interest of society as a whole.

Q: What risks do you foresee with the take-over?

I have concerns about two pieces of the plan: the continuation of payments to the subordinated debt holders, and the purchase of additional mortgage-backed securities by Fannie, Freddie, and the Treasury. Continuing payments to this set of debt holders will help to stabilize financial markets. However, the crucial role of subordinated debt for any company is to create a group of investors who know they will lose if the company fails, so that they scrutinize and attempt to influence the company’s actions, and so that the price of the debt is a visible signal of the perceived risk of the company failing.

By continuing to make payments on Fannie and Freddie’s subordinated debt, the rescue plan risks setting a precedent for rescues of other financial institutions and thereby undermining this market discipline.

The purchase of additional mortgage-backed securities for the Fannie and Freddie portfolios (up to roughly $150 billion) and for the Treasury (in unspecified amounts) will offset some of the recent fall in demand caused by a pullback of foreign and domestic investors. Thus, the purchases serve a worthy short-term stabilizing role in the mortgage market.

However, increasing the size of Fannie and Freddie’s portfolios goes in the opposite direction of the appropriate long-run goal to reduce the scale of these enterprises (however we resolve the public-private problem).

Moreover, direct Treasury purchases of mortgage-backed securities are a significant new step toward a larger government role in supplying funds for housing, which may complicate an appropriate long-run resolution of the public-private hybrid problem.