WASHINGTON — Barack Obama and John McCain agree that it was necessary for the federal government to seize mortgage-finance giants Fannie Mae and Freddie Mac. They aren't as sure, however, about what to do with the companies once one of them takes office.
McCain would privatize Fannie and Freddie, but has not said how. Obama believes the two cannot return to the way they operated before, but is undecided on the best way forward.
Fannie Mae and Freddie Mac own or back more than $5 trillion in mortgage debt, more than half of the U.S. mortgage market. Even before the Treasury's seizure last weekend of Fannie and Freddie, economists already were debating what was best for them: privatization, nationalization or continuing as quasi-public-private companies, only perhaps smaller than their present form.
That debate took on new urgency after Treasury Secretary Henry Paulson announced last Sunday that he was taking over the two under a procedure similar to Chapter 11 bankruptcy to restructure them.
Fannie and Freddie are oddities; they have long been believed to have the backing of the U.S. government should trouble arise, but they operated as private companies making profit for shareholders. That mission at times conflicted with the mission of their government charter — to promote homeownership by lowering borrowing costs.
Fannie and Freddie buy mortgages from commercial banks and other lenders, then pool the loans and package them into bonds called mortgage-backed securities. Investors have traditionally bought these bonds as safe bets, and by getting the loans off their books, banks were free to lend more to consumers, lowering mortgage costs.
But during the housing boom of 2001 to 2006, big investment banks began competing against Fannie and Freddie and taking their business. The investment banks issued their own mortgage-backed securities, called private-label mortgage-backed securities. Many of these bonds were backed by Alt-A and subprime mortgages — home loans issued to borrowers with weak credit. This practice helped inflate the housing bubble, which burst in the summer of 2007 and became the worst housing crisis since the Great Depression.
Republican presidential nominee McCain has long been a critic of Fannie and Freddie. McCain called for their privatization in a Tuesday opinion column in The Wall Street Journal that amounted to an "I told you so."
"Enduring reform of Fannie and Freddie is a key first step. We will make sure that they are permanently restructured and downsized, and no longer use taxpayer backing to serve lobbyists, management, boards and shareholders," McCain wrote.
Much of the column was devoted to needed reforms in the housing market, leaving the impression that Fannie and Freddie had something to do with causing the current meltdown. They didn't. The problems were brought about by the private sector and insufficient federal and state regulation over the housing market. Treasury Secretary Paulson said Sunday that if not for Fannie and Freddie, the housing crisis would be far worse.
Going forward, Republicans and Democrats agree on one thing: Fannie and Freddie should be smaller to reduce the threat they pose to the financial system. But the chairman of the Senate Banking Committee, Christopher Dodd, a Connecticut Democrat, warns against a wholesale closure of Fannie and Freddie.
"If you are going to eliminate this, what are you going to replace it with? And if not, how do you expect homeownership" to rebound and grow, he asked. "Fannie and Freddie did not go out and buy loads and loads of subprime mortgages. Fannie and Freddie have been the salvation. ... Be careful what you wish for."
The committee's ranking Republican, Sen. Richard Shelby of Alabama, told CNBC on Wednesday that Fannie and Freddie need to shrink, but that he doesn't advocate privatization.
Even before their seizure, Democratic presidential candidate Obama had described Fannie and Freddie as a "weird blend" and questioned whether the public's interest was being served best by the current structure.
In an interview, his chief economic adviser, Jason Furman, said the question of what do with Fannie and Freddie going forward is a tough one.
"What's clear is you don't want to return to the status quo, but you want a solution that is mindful to the fact that Fannie and Freddie do a whole range of things ... some that the private sector doesn't do," Furman said. He suggested that Obama would seek to disentangle the mortgage-finance companies and narrow their mission to boosting home ownership.
"Obama has been very clear and very direct about the flaw in their business model. ... He thinks it's important that we make major changes, that we end Fannie and Freddie as we know them. But that means we need to find another way to accomplish a lot of the important things that they do accomplish," Furman said.
Among options that Democrats would consider is smaller versions of Fannie and Freddie in their current hybrid form, or nationalization that could involve the government purchasing outstanding shares of Fannie and Freddie and returning them to their original purpose as a tool to promote homeownership.
"We absolutely need change, we cannot have the status quo, but it is a complex problem," Furman said. "And it's going to take a complex solution, not a simple ideological recipe."
McCain favors privatizing Fannie and Freddie. His chief economic adviser, Douglas Holtz-Eakin, said the two grew too large, worked against the interests of homeowners and fended off tougher regulation through lobbying.
"I won't pretend that we're in the position of writing the details of a legislative proposal, but the key would be to remove this constellation of special provisions" enjoyed by Fannie and Freddie, he said.
Like the Obama camp, McCain's team wasn't ready with detailed proposals. One option is to sell off the assets, another is to place Fannie and Freddie under a new charter that allows them to retire their old obligations while new ones would explicitly get no government support.
Holtz-Eakin said that however it happens, the goal is to "break entirely the link between the federal government and Freddie Mac and Fannie Mae."
Some finance experts think the best option is either nationalization or privatization — not a smaller version of the mixed public-private status quo.
"The mixed model doesn't work," said Vincent Reinhart, a former top economist at the Federal Reserve. "Economists would agree that either corner is somewhere better than being in the middle."
One immediate consequence of the government takeover: A powerful lobby has been silenced. Fannie and Freddie were ordered immediately to cease lobbying Congress. They donated $4.8 million to current members of Congress from both parties, with Democrats getting 57 percent of that amount. That's according to the Center for Responsive Politics, which tracks lobbyist spending.
The current and former chairmen of the Senate Banking Committee, which oversees the two, were big benefactors, the center said Thursday. It reported that current chairman Dodd received $165,400 from Fannie and Freddie and their employees from 1989 to 2008, the most of any lawmaker. Past Chairman Shelby received $80,000 during the same period.
Obama, with far less time in the Senate, received $126,349, behind only Dodd. Almost all of Obama's contributions came from individual employees and not political-action committees.
Although he did not receive campaign contributions from Fannie and Freddie, McCain held about $10,000 of stocks and bonds issued by the two companies — and like many individual investors, he's likely to see some losses in the takeover.
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