Why Give Taxpayers' Money to Freddie Mac and Fannie Mae's Shareholders?

Should the government cover a private company's losses during bad times, but let it keep its profits during good ones? It doesn't sound like a very good deal for taxpayers. But that is how we treat Fannie Mae and Freddie Mac, the two big corporations that make loans and loan guarantees as well as handle the secondary mortgage market in the US.

As most probably suspect, this whole approach is pretty dubious. If you subsidize risk, you get more of it. If you don't have to bear the cost of the risk, why not shoot for the moon? Economists believe that the federal government subsidizing risk is what caused the whole saving and loan meltdowns during the 1980s.

On Saturday, the Senate followed the House and overwhelmingly passed a massive “housing bill” that promises an unlimited line of credit to Fannie Mae and Freddie Mac. Of course, these two companies already get all sorts of preferential treatment. For example, they are exempt from all state and local income taxes.

Both Fannie Mae and Freddie Mac's stocks have fallen in the last couple of months, but neither are going insolvent anytime soon, even without the new government funds.

Nor have these two companies been the best run organizations. As one academic journal put it: “In 2003, the Office of Federal Housing Enterprises Oversight (OFHEO) investigated Fannie Mae and found a culture of corruption, arrogance, and pervasive accounting violations in the company. Executives at Fannie Mae cooked books to pocket an extra twenty-seven million dollars in bonuses.” Franklin Raines was forced to resign as head of Fannie Mae.

The question is that no matter what the losses suffered by Fannie Mae and Freddie Mac's shareholders, why should the taxpayers pick up these losses?

The new legislation contains all sorts of other goodies, including $300 billion for FHA-insured mortgages and tax breaks for home buyers. But the notion that this bill is just aimed at helping out the housing prices is hard to take seriously. Take just one provision: the $7,500 tax credits that are retroactive for those who have bought their houses even back in April, almost four months ago.

How does giving someone who bought a house on April 1st an extra $7,500 from taxpayers increase the price of houses today? Did anyone who bought a house then seriously expect to get that much money back from the government for buying a house? This $7,500 is just a windfall to those who bought houses over the last four months.

President Bush first opposed the “housing bill,” but caved last week to political pressure to appear to be doing something about the housing mess. Senator Obama issued a press release last week praising the legislation.

Of major political figures, only Senator McCain stood alone, not only saying that "Americans should be outraged at the latest sweetheart deal in Washington,” but calling to eliminate these companies' special status. McCain not only called for the two companies to end their multimillion dollar lobbying campaigns, but, more importantly, legislation "making them [Fannie and Freddie] go away."

If Democrats were really serious about trying to strengthen the housing market, here is one suggestion: stop promising policies that will drive down prices. Obama's plan to double capital gains taxes will obviously drive down house prices. As Obama's probability of winning increases and you are more likely to get hit with this higher tax rate, do you want to sell your house now or wait until after the beginning of the year when his tax increase goes into effect?

The irony is that Obama and the Democrats are simultaneously supporting a tax credit for home buyers to prop up the prices of houses and yet they are supporting large tax increases for many next year, tax increases that lower prices. Why not just leave all these tax changes alone?

Other proposals by Obama such as allowing bankruptcy judges to rewrite mortgage agreements dry up credit markets even before they are enacted. If you were a lender, why would you sign a contract with a home owner if the terms of the contract could be rewritten at some future date?

As Obama's chances of victory this November increase, the likelihood of these regulations rises and both house and stock prices fall.

Fannie Mae and Freddie Mac have been exempt from all sorts of regulatory requirements and costs imposed on their competitors. No Securities and Exchange Commission (SEC) regulations apply to them. The “housing bill” changes this some, but instead of putting the two companies under the same regulations as every other company, a new regulatory agency is being set up just for them.

Even though government regulation were responsible for the original sub-prime mortgage problems, by forcing loans to risky borrowers whom lenders otherwise never would have considered, the solution seems to be more regulation in the form of this hastily written “housing bill.” The solution to regulatory problems always seems to be new regulations, new taxes and subsidies, and not a serious reevaluation of the rules that caused the mess to begin with.

The government goes from one extreme to another. Previously forcing loans that lenders did not want to give and now trying to prevent loans that lenders wanted to give. Helping to dry up credit and helping force housing prices down. Then we have some subsidies that try to offset that and raise prices, and other future taxes doing the opposite.

But why is John McCain the only national politician to question these massive government subsidies to shareholders? Why perpetuate rules that subsidize risk-taking behavior with government money? Years from now we will wish we followed McCain's advice and made these quasi-government agencies “go away."

*John Lott is the author of Freedomnomics and a senior research scientist at the University of Maryland.