Guaranteed To Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance. Viral V. Acharya, Matthew Richardson, Stijn Van Niewerburgh, and Lawrence J. White. Princeton University Press 2011, 222 pp. $24.95.

Guaranteed To Fail is timely collaborative effort by professors at New York University’s Stern School of Business. In this academic monograph, the authors argue that, despite the fact that they contributed significantly to the financial crisis of 2007-09, “Fannie and Freddie barely register as news.” This new book is a bold, and overall successful, attempt to demonstrate the centrality of Fannie and Freddie to the recent financial crisis in which banks failed, credit markets dried up, and the federal government stepped in to bail out supposedly too-big-to-fail institutions. In Guaranteed To Fail, the authors provide ample evidence that the flawed business model of Fannie and Freddie (“they were run as the largest hedge fund on the planet”) contributed significantly to the largest economic downturn in the United States since the Great Depression.

The authors begin with a concise and understandable overview of Fannie Mae and Freddie Mac’s history and mission. They emphasize that the two GSEs (government-sponsored enterprises) had two main functions, residential mortgage securitization and residential mortgage investment. Fannie Mae’s conversion into a private company in 1968 and the Housing and Community Development Act of 1992, which gave the GSEs a mandate to expand homeownership for lower-income persons, had significant impacts on the mortgage finance market. In the authors’ view, the mission goals of the Community Development Act “essentially gave the GSEs a mandate to purchase lower-quality mortgages. These riskier mortgages received the same implicit government guarantees nevertheless.”

Indeed, the main argument of Guaranteed To Fail is that Fannie and Freddie were fundamentally flawed because they were too-big-to-fail, were incentivized to take on increasingly risky investments with implicit government guarantees, and had a business structure that privatized gains and socialized losses. Because of this, Fannie and Freddie damaged the free market system for mortgage finance. The authors emphasize that, after the deregulation of the mortgage finance market beginning in the 1980s, Fannie and Freddie benefitted from their perceived government guarantees. “But there as nothing free about these markets . . . Fannie and Freddie had a special status, which meant that the financial markets believed that there were implicit government guarantees on any debt that they issued and on the mortgage guarantees that they provided.” Politicians, the authors note, did little to mend this state of affairs. “There was no one left to restrain Fannie and Freddie, of course, other than the federal government; but in the myopic goals of boosting home ownership at all costs, each successive presidential administration turned a blind eye.” The authors, like others before them, have serious reservations about the federal government’s role in subsidizing home ownership through tax policy and low interest rates, a theme they develop in their last chapter.

If Fannie and Freddie have proved to be such a debacle, what is the most workable solution to this overarching problem? Here, the authors are blunt in their overall assessment: “nothing short of bringing the shutter down on Fannie and Freddie in the long run will suffice.” That said, after several chapters of diagnosing the problem with clarity, including a notable chapter in which they argue against the wisdom of keeping GSE securities on the Federal Reserve’s balance sheet, the authors articulate a potential solution to the ongoing problem of Fannie and Freddie. Opposed to permanent nationalization, the authors contend that they are “agnostic with respect to the complete privatization option, at least in the near term.” Instead, they offer what they term “a pragmatic middle ground” in the form of a “public-private partnership for the guarantee business” in which “the private insurance market would help to establish a market price for mortgage default risk” and wherein the government would provide capital for the remaining mortgage insurance. They propose a 25%-75% model, in which the private insurers have a 25% stake and the federal government is “a silent partner in this effort, simply providing capital for the remaining 75% of the mortgage insurance and collecting fees on the 75%, albeit using a price determined from the mortgage insurance company’s 25% stake.” They call for the establishment of a new government agency, the Government Mortgage Risk Corporation (GMRIC) that would, in their view, “be a boring government-run utility with the sole purpose of passively co-insuring the credit risk on conforming (core) mortgages.” It should be noted that the authors do not envision the private-public partnership to be viable for the nonconforming loan market.

Guaranteed to Fail is a must read for persons working on or interested in GSE reform. Although the authors could have devoted more attention to the complex and nuanced politics of housing issues in Washington, they succeeded admirably in demonstrating that politicians need to be bold and constructive in their approach to winding down the GSEs. One could easily envision a follow up monograph in which the authors devote their full attention to the wisdom of government subsidies to homeownership. In conclusion, the authors have written a useful, albeit not completely original, primer on why Fannie and Freddie failed and why the government must withdraw from the business of distorting the market for mortgage finance through implicit guarantees. Only then will the federal government’s involvement in mortgage default insurance not be guaranteed to fail.
Jon Lewis (c) 2011