The Problem With Being “Too Big To Fail”

“Too big to fail” is a nifty bit of rhetoric swirling around Washington right now regarding Fannie Mae and Freddie Mac. Yes, the government-sponsored mortgage giants do play a crucial role in the US housing market, funding or guaranteeing more than half of all mortgages. Clearly, a failure at either institution would be catastrophic for the domestic housing market, but their size is also a hindrance to their purpose. To understand this, one must realize where these two behemoths came from.

Created in 1938 as part of Franklin D. Roosevelt’s New Deal, the Federal National Mortgage Association, or Fannie Mae, was established to facilitate home ownership in America following the Great Depression. At the time, mortgage funding was unreliable and expensive, preventing many Americans from buying their own homes. The creation of Fannie Mae provided the funding necessary to lower barriers to home ownership. For nearly 30 years, Fannie Mae dominated the secondary mortgage market, buying home loans from other banks in order to free up those funds for new mortgages. Throughout this period, Fannie Mae was part of the federal government, representing a substantial burden on the federal budget and a barrier to entry for competition. In 1968, in response to these concerns, Fannie Mae was rechartered as a government-sponsored, publicly-traded entity. At the same time, Congress created the Federal Home Loan Mortgage Corporation, or Freddie Mac, to provide competition for the newly-independent Fannie Mae. The federal government hoped that by placing both companies in the private sector, competition would be created in the secondary mortgage market.

Over the next 40 years, Fannie and Freddie grew into their roles in the mortgage market. By 2008, the companies together guaranteed more than $5 trillion in mortgages, representing more than half of the market. It is because of their size that everyone from Treasury Secretary Henry Paulson to Senator Chris Dodd (D-CT, Banking Committee Chair) insists their failure must be prevented. While I understand how important their role is in the mortgage market, I do not think it is imperative that they continue in their current form.

Monopoly and competition are rarely complementary concepts. This is especially true in the case of Fannie Mae and Freddie Mac. While the later was originally intended to compete with the former, nowadays there is little difference between them. Rarely is one mentioned in the news without the other accompanying it. Because of their size and near homogeneity, increased regulation will have no impact on competition in the secondary market. Instead, both should be broken up into smaller entities. Doing so will allow them to operate as they were intended, competing with each other for a share of the mortgage market. In the following clip from Bloomberg Television’s Morning Call, Marc Faber, editor and publisher of “The Gloom, Boom, and Doom Report” makes his argument for the breakup of Fannie Mae and Freddie Mac.

As Mr. Faber pointed out at the end of this clip, the federal government has stepped in before to break up a monopoly, namely in the cases of Standard Oil and AT&T. Competition was created when those two behemoths of their industry were split up. The same should be done with Fannie and Freddie.

The “baby Maes” which would result from a breakup of Fannie Mae and Freddie Mac would need to retain many of the characteristics of their parents in order for them to be successful. Government sponsorship is important as it reassures investors and carries with it an implied guarantee, thereby allowing more investors to purchase securities issued by the companies. By placing more companies in the secondary market, a breakup would foster competition, thereby lowering borrowing costs for would-be homeowners. Splitting up the entities also reduces the risk assumed by the government should one of the entities falter. Current plans to bolster Fannie Mae and Freddie Mac could cost taxpayers as much as $25 billion if either failed, according to the Congressional Budget Office. By breaking the companies up, the failure of one would not damage the entire mortgage system, and the cost to taxpayers would be reduced significantly.