Phase out Fannie and Freddie

What an outrage. Uncle Sam has spent more than $160 million on legal fees to defend former officials of Fannie Mae and Freddie Mac. Worse yet, these are some of the same individuals who ran the companies into the ground.

Infuriating as this may be, the sum involved is chump change next to the more than $150 billion the government takeover has already cost. The worst of the losses is behind us, but we'll be stuck with Washington's problem twins for years to come.

The question now is, what is to be done? The answer is of more than academic interest because how and when we get rid of these two deadbeats is important for everyone in America who might ever want to own a home.

First, a little background: Fannie (originally the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.) were created by the government - and then cut loose as businesses - to give lenders cash for their mortgages, freeing up money for new loans. They now buy two-thirds of new mortgages, bundling them into securities sold to investors, and 90 percent of new mortgages carry a government guarantee of some kind.

Absent Fannie and Freddie's purchases and guarantees, today's anemic housing market would collapse.

In the long run, when the foreclosure crisis is past, we shouldn't need Fannie and Freddie or government mortgage guarantees - and over time, we can eliminate both. But we should face the fact that without either, traditional mortgages will become pricier and harder to obtain.

That runs counter to the idea that every American somehow ought to be a homeowner, and the looser lending standards that, for a while, borrowers and lenders embraced.

If we do want broad access to cheap, long-term mortgages, then we'll need someone to continue turning home loans into securities. That's because banks no longer have a steady, predictable long-term source of cheap money for home loans, as they did back in the days when George Bailey, the saintly hero of "It's a Wonderful Life," was giving out mortgages in Bedford Falls. Back then, inflation was low and Uncle Sam capped how much interest banks - and later, thrifts - could pay on deposits.

Lacking a reliable fount of cheap deposits, lenders wouldn't have much interest in giving us the 30-year fixed-rate mortgages we love, complete with the right to prepay if interest rates move in our favor - unless they can bundle these loans into bonds in a process called securitization.

This was supposed to make the financial system safer. Unfortunately, it had the opposite effect leading up to the financial crisis. It turns out that lenders who package and sell off their mortgages tend to get careless about who they give loans, because they make their money on fees. And when banks hold a lot of these mortgage securities, risk can be concentrated disastrously. But if we want cheap loans, we'll have to learn to manage the risk. Securitization is here to stay.

And it's a job that can be done by the private sector. As businesses, Fannie and Freddie did a pretty good job of it for years, until they took on too much risk. But if the lending giants were phased out and mortgage securities were issued and held privately once again without exceedingly strict government standards, we might see a repeat of the mortgage meltdown that triggered the last financial crisis. That could force taxpayers, yet again, to assume the debts of reckless firms considered too big to fail.

Bundling mortgages into securities could also be done by a federal agency. Unlike Fannie and Freddie, after all, a government agency wouldn't have greedy executives or troublesome lobbyists. And a government agency would lack incentives to take too much risk. But there would be great political pressure to maintain government guarantees - and to charge too little for this most coveted form of investor insurance.

Confronted with Hobson's choice, we prefer a private-sector solution without guarantees from Uncle Sam. Fannie and Freddie could be wound down over perhaps a decade - and investors could fend for themselves.

Either way, it's crucial that we more closely regulate the mortgage business, from loan standards to the process of bundling mortgages into bonds, because if we don't, taxpayers could end up on the hook yet again.

These changes inevitably will make borrowing tougher - as it should have been all along.

If this seems a high price for borrowers to pay for financial stability, get a load of the price they pay in Canada, which has a similar rate of home ownership but a much more stable financial system.

Up there, mortgages typically run two to five years, after which you get a new interest rate - and go through a new approval process. If you can't requalify, banks typically work to keep you in your house, and default rates are low.

A 20 percent down payment is standard in Canada, and prepaying the mortgage is costly. There is much less securitization. And mortgage interest isn't tax deductible, as it is here, so Canadians don't have as big an incentive to buy too much house.

Many of these tough-love ideas are excellent. But because of opposition from so many interested parties - homeowners, real-estate agents and others - they probably don't have a chance of being adopted in this country. But we're likely to become a little more Canadian in our lending practices nonetheless.

Mortgages will cost more and require bigger down payments. They may even saddle borrowers with more interest-rate risk. That won't be entirely pleasant. But when it comes to reducing the odds of yet another global financial crisis, it's a matter of no pain, no gain. hN