Fannie Mae and Freddie Mac must go

At the time, it was perhaps the biggest bailout in US history. Today, one month later, the federal takeover of mortgage giants Fannie Mae and Freddie Mac has been all but forgotten in the drama of the global credit crunch.

Washington careened off to pass a bigger bailout before a clear plan emerged about Fannie's and Freddie's future. The uncertain cost of their conservatorship is sobering enough, but a more subtly troubling matter is what to do with them after things settle down. There are several options, but history gives a clear warning: Nationalization of industry is easy; privatization is hard.

Some say that this is uncharted territory, but that's flat wrong. Washington has tried to privatize Fannie Mae before. In 1968, Fannie was a government agency that had been serving to inject liquidity in the housing market for 30 years, but finally President Johnson signed legislation ordering it out of the governmental garden. Easier said than done, as it turns out.

Fannie was given a new corporate charter and soon after, in a slight twist on Genesis, a manly mate for company, Freddie Mac. It was hoped that the two firms would propagate a new, competitive secondary mortgage market outside of Eden.

Fannie and Freddie instead decided they liked Eden just fine, thank you. They didn't leave, few complained, and nobody else horned in. The secondary mortgage market remained a haven practically closed to others because of the implicit guarantee that the two government-sponsored enterprises would be rescued by that supreme sponsor if they ever got into trouble. This gave Fannie and Freddie two preemptive advantages over potential competitors: the cost of their funds and their capital requirements were both lower. Fractional marginal advantages are killers in finance when you start multiplying into the trillions.

Things greened up nicely in the garden of the secondary mortgage market until la-la accounting practices called attention in 2003 and 2004 to the curious, hothouse nature of these entities and their almost surreal approach to finance. Rather than figure out how to disentangle Fannie and Freddie from the government garden, though, Congress opted instead to press them into "service" to fertilize housing finance beyond traditional limits of prudence. We then got wild growth in lending, complete with no-doc loans, nothing-down houses, equity-line hustles, phony appraisals, and gyrating figures on every computer screen gleefully shaking the money tree.

When Fannie and Freddie were finally nationalized, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke only briefly touched on the issue of what to do with them in the long run. The current thought is to downsize them gradually at a rate of 10 percent per year, slowly privatizing the field.

But a mechanistic form of gradual privatization seems as unlikely to work as the attempted privatization of Fannie in 1968. Why would a private competitor want to compete at all with a couple of subsidized favorites? How can government be in a field without dominating it?

As Russia and China have discovered, it's very hard to privatize any sector of the economy long dominated by government. But at least those countries know something about the subject. In a rather strange turnabout, America might be well served by looking into their experience in privatization for useful lessons (while perhaps snaring some advice on the interim problem of how to run a hale and hearty system of financial socialism). In any event, our own limited experience on the subject of privatizing the secondary mortgage market is definitely not worth repeating.

One promising alternative to consider is to have the users of the service – the banks and other mortgage originators – create and mutually own new loan clearinghouses to do the useful business conducted by Fannie and Freddie. That basic concept of mutual ownership has worked well in the credit card business.

However, those kinds of cooperatives can only work if government competitors clear out. When government gets into a clearing business or regulates it to the point of close confinement, the private entities and innovation disappear, as happened in the check-clearing business early in the 20th century.

Whatever the path to privatization of the secondary mortgage market, though, one precondition for success seems likely: Fannie and Freddie must go.

• David G. Oedel is a professor of law at Mercer University Law School.