Don’t hand Fannie, Freddie over to the Fed

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A recent article in the American Banker asked whether Fannie Mae and Freddie Mac should be designated as systemically important financial institutions, or SIFIs, by the Financial Stability Oversight Council. That would turn them over to the Federal Reserve for more stringent regulation than they currently receive.

Fannie and Freddie are surely problem children, but making them wards of the Federal Reserve is a very bad idea. It would do nothing to stop the destructive housing finance policies Fannie and Freddie currently pursue, but would assure that another major sector of economy would fall under the Fed’s permanent control.

The first and most obvious question is this: Why would the Fed, which knows next to nothing about housing finance, be a better regulator than the Federal House Finance Agency, the current regulator and conservator of both Fannie and Freddie? When it was established in 2008, the FHFA was said to have all the powers of a “world class regulator.” It has even more powers now as their conservator. At the very least, the FHFA is expert in housing finance; the Fed, at the very most, is not.

The Fed, moreover, has failed even in its current assignment as a monitor of the economy’s health. Some might recall, for example, that the Fed did not anticipate the 2008 financial crisis. Ben Bernanke, then the Fed’s chair, famously told Congress, just before the crisis, that the subprime mortgage problem was “contained.” It’s true that many other officials also failed to see the crisis coming, but those other officials do not have a staff of over 900 Ph.D. economists constantly analyzing the financial system for impending danger.

Leaving aside its failure to foresee the crisis, the Fed did not cover itself with glory as a bank regulator either. Banks and bank holding companies — regulated by the Fed — were among the most seriously affected financial institutions when the financial crisis finally struck. That was a black mark in itself for the Fed, but it turned out that the Fed had allowed many of them to place billions of dollars in mortgages off their balance sheets, in trusts financed by short-term loans from money market funds. This, as long as it lasted, gave these institutions the appearance of strong capital positions. But when those loans were not rolled over in the crisis, these low quality mortgages had to be brought back onto the banks’ balance sheets, causing substantial losses and weakening their capital positions.

And then there are the conflicts of interest. The Fed’s original and most important role is that of central bank, stabilizing interest rates for the good of the economy as a whole. This creates a conflict of interest with its bank regulation, since raising or lowering interest rates under some conditions can weaken the banking system. Thus far, Congress has ignored this serious problem. But imagine the conflicts if the Fed were actually the regulator of the dominant players in the housing finance system. Rates that will stimulate housing could be problematic for banks, for a stable currency and for the economy as a whole — and yet, rates that might be necessary to protect the economy could seriously weaken Fannie and Freddie.

And then there is the regulatory greediness of the Fed. All regulators want to hold on to power and expand it, if possible. In this, the Fed has been a standout. It was established in 1913 as the nation’s central bank to prevent recessions and bank failures caused by lack of liquidity; nevertheless, these continued and in many ways got worse, culminating in the Great Depression of the 1930s.

But the Fed continued to seek more power, complaining to Congress in the mid-1930s that it was dangerous for banks to be affiliated with or controlled by other businesses, unless these businesses were regulated by the Fed. In 1954, the Fed was finally given the power to regulate one-bank holding companies. It then pressed Congress to let it regulate holding companies that controlled more than one bank, and got that authority, too, in 1970.

All this occurred in the deregulatory period of the 1970s and 1980s, when New Deal-based restrictions on air travel, trucking, railroads, telecommunications and securities were abandoned — much to the benefit of consumers and economic growth. But during this period, the Fed managed to keep its control of banking intact. One of the reasons that banks have such difficulty attracting capital is the Fed’s restrictive regulation of the activities of bank holding companies.

Nevertheless, after the financial crisis in 2008, which highlighted the Fed’s failure as a regulator, Congress gave it more new authority in the Dodd-Frank Act than any other financial regulator — including, among many other roles, the authority to regulate SIFIs, the risk-management activities of the new clearinghouse system for financial transactions, and the liquidity rules for bank holding companies.

Imagine, then, what would happen if the Fed were to gain control of the housing finance industry through Fannie and Freddie’s designation as SIFIs. There would be no improvement in regulation, since the Fed has never succeeded in that — even with banking. The Fed’s conflicts of interest would multiply, to the point where no one would be able to untangle the basis for its decisions. And worst of all, any hope of reforming the housing finance system would be lost as the Fed — with the help of the powerful housing lobby — shows its uncanny ability to keep Congress away from its various regulatory properties.

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