Fixing Too Big to Fail

By Theodore Cangero

Regulators misdiagnosed the causes of the 2007–8 financial crisis when they blamed private sector greed and largely ignored the role of government policy, which in fact laid the groundwork for the financial crisis. But the CBO has introduced an intriguing solution to the failed policies from before and after the crisis.

In particular, the Community Reinvestment Act compelled banks to make mortgage loans to buyers with poor credit histories. The government then encouraged government-sponsored enterprises Fannie Mae and Freddie Mac to purchase the high-risk mortgages.

The Great Recession was triggered by a collapse in artificially high home prices. As housing prices fell, borrowers found themselves owing more than the homes were worth. As a result, many borrowers defaulted on their mortgages. Defaults reduced the value of mortgage-backed securities and other derivatives linked to the mortgage market. Fannie and Freddie teetered on the verge of bankruptcy because of the toxic mortgage-backed securities on their books. The federal government stepped in and nationalized Fannie and Freddie because they were “too big to fail.”

After the financial crisis, Congress passed the Dodd-Frank Act to end the “too big to fail” policy. However, AIER contributor Sheldon Richman points out that “too big to fail” lives on. The government is still allowed to purchase assets at face value from failing financial institutions.

Policy needs to restore a larger role for the private sector in the mortgage market to reduce taxpayers’ exposure to the risk of default and costly bailouts, and to make financial markets more stable.

The Congressional Budget Office recently offered a plan to reduce the size of Fannie Mae and Freddie Mac. The plan attempts to reduce the size of Fannie’s and Freddie’s mortgage portfolios in two ways. First, the maximum size of a mortgage that Fannie and Freddie could include in their mortgage-backed securities would be reduced. Initially the maximum loan size would be reduced from over $600,000 to $400,000. By 2026, the loan size would be reduced to just $175,000. According to the CBO, the reduction would shrink Fannie’s and Freddie’s mortgage portfolios by $1 billion between 2017 and 2026.  

Second, the fees that Fannie and Freddie assess for guaranteeing their loans would immediately increase by 10 basis points, raising borrowing costs. This would keep risky borrowers on the sidelines until they had more capital. Fannie and Freddie would be required to pass the fees through to the Treasury, which would contribute $6 billion to federal finances between 2017 and 2026.

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