The one silver lining to the dark cloud in financial markets is that it is no longer tenable to credibly argue in favor of government-sponsored enterprises such as Fannie and Freddie. These corrupt entities played a significant role in causing the real-estate bubble, and politicians — if they had any sense — should liquidate Fannie and Freddie now that they are officially insolvent.

Let’s quickly review why Fannie and Freddie should have been shut down and also show how they contributed to the financial mess.

  • Fannie and Freddie were explicitly designed to divert capital into residential real estate. The implicit (now explicit) government guarantee meant that interest rates for home mortgages were subsidized compared to rates for other forms of borrowing. This does not necessarily cause systemic risk, but it does harm long-run economic performance by soaking up funds that otherwise would have been used for business investment.
  • Fannie and Freddie were perverse examples of crony capitalism. An important feature of a genuine free market is that everybody plays by the same rules. But the interest-rate subsidy available to Fannie and Freddie gave them a huge advantage over other companies. Ironically, much of that subsidy wound up lining the pockets of the political elite that somehow — notwithstanding a total lack of real-world business acumen — wound up getting top slots in the Fannie and Freddie hierarchy.
  • Fannie and Freddie expanded their activities beginning in the 1990s, shifting from being akin to a subsidized investment bank that issued mortgage securities to being akin to a savings and loan institution on steroids. In effect, Freddie and Fannie became their own biggest customers, issuing debt to amass huge portfolios of securitized mortgages. This destabilized the entire financial system by contributing to the housing bubble. A few policymakers tried to rein in the worst excesses, but they were blocked by politicians such as Rep. Barney Frank and Sen. Chris Dodd, all of whom were major recipients of campaign contributions from Fannie and Freddie.
  • In 2000, Bill Clinton’s Department of Housing and Urban Development made a bad situation even worse by imposing so-called affordable-housing quotas on Fannie and Freddie. The government-sponsored enterprises responded by becoming huge purchasers of securities containing subprime mortgages. This further contributed to systemic instability and the housing bubble. The Bush administration added fuel to the fire in 2004 by increasing the affordable-housing quotas, and Fannie and Freddie responded by lowering the standards for mortgages they would purchase for securitization.

There is a lot more that can be written about Fannie’s and Freddie’s mistakes and their corrupt symbiotic relationship with the political class, but there’s only so much that can be said given space limitations.

The key question is what should be done now that Fannie and Freddie are on life support. If there is any common sense in Washington, they will be shut down. The simplest approach, at least once the financial crisis has passed, is to cease and desist any new securitization (leave that function to real private-sector companies) and to pay off existing debt as the securities and mortgages in their portfolios mature.