Should Fannie and Freddie Raise Mortgage Rates?

There has been a lot of debate over the last couple of years about the role that Fannie and Freddie played in the financial crisis, and what should be done with them moving forward.  There is considerable disagreement over how much culpability the GSEs bear for the housing bubble (reasonable people say they were just one of many causes, while the self-delusional lay the bulk of the blame at their feet).  The Dodd-Frank financial reform legislation required the Treasury to issue a report on the future of Fannie and Freddie (the report was recently delayed).  Rep. Jeb Hensarling is proposing legislation that would phase out Fannie and Freddie over the course of five years.

In any case, John Hempton addresses this situation in this guest post on Nakedcapitalism.com, which I recommend reading in full.  His solution is fairly simple:

“There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation. They argue that government intervention has to end and then propose a system with a permanent role for government. It is not just nonsensical – it is usually in the interest of some large financial institution. All they want is Frannie out of their part of the business. They like government subsidies in the rest of their business.

Anyway I have the free market solution to the Fannie and Freddie situation – and – I hate to say it – it is dead obvious.

Answer: raise Frannie’s pricing.”

Hempton contends that the reason Fannie and Freddie dominate the conforming mortgage market is because private investors cannot (or will not) profitably compete with the mortgage rates the GSEs offer.  More specifically, private investors won’t take the risks that the GSEs take at the interest rate spread they accept.  He says that if Fannie and Freddie slowly raise their rates two things will happen: private investors will return to the conforming market, and the government will be better compensated for guaranteeing mortgages.

Hempton says that the GSEs should keep raising rates, even after private investors begin to come back to the conforming mortgage market.  Very slowly, this would make Fannie and Freddie non-competitive, and shrink their market share over time until they eventually go away.  How slowly or quickly rates would be raised would all depend upon the time table for phasing out Fannie and Freddie.

This plan would cause mortgage rates to increase for most borrowers, but done over time the shock to the market wouldn’t be that great.  As long as this plan were enacted at some point in the future (after the housing market has pulled out of its current nosedive and stabilized to some degree), I can see it being a viable solution to the Fannie and Freddie problem.  What do you think?  Do you have a better idea?  Let me know in the comments section below.