How big should Fannie and Freddie be?

Not as big as they are, says Alan Greenspan. In testimony to the Senate Banking Committee today, the Fed chairman argued that increased regulation isn't enough -- Fannie and Freddie are dangerous not just because they're sloppy or corrupt, but because they're enormous. The only solution is to force them to reduce the size of the investment portfolios they hold.

Now, Greenspan didn't utter the "p" word, so you can't discern any particular attitude towards privatization from his remarks. And some might argue that his emphasis on better regulation implies that he thinks Fannie and Freddie should continue operating under their congressional charters.

But clearly he is deeply skeptical about their current business models, and in particular about their argument that holding any sort of portfolio in their own mortgage-backed securities is beneficial for mortgage markets:

A recent study by Federal Reserve Board staff found no link between the size of the GSE portfolios and mortgages rates. The past year provides yet more evidence, with GSE portfolios not growing and mortgage spreads, as well as the spread between yields on GSE debentures and Treasury securities, declining further. Indeed, while GSE stock prices have fallen substantially and turmoil has continued at the GSEs, mortgage markets have functioned well.

As far as we can tell, GSE mortgage securitization, in contrast to the GSE's portfolio holdings, is the key ingredient to maintaining and enhancing the benefits of the GSEs to homebuyers and secondary mortgage markets.

Translation: If Fannie and Freddie had just stuck to doing what they were originally intended to do, we wouldn't be here today.

The other notable aspect of this testimony is Greenspan's emphasis on the importance of giving the GSEs' regulator receivership powers. Even though investors and creditors assume it would never happen, there is some legal provision for GSE insolvency. However, those rules are weak and vague. The crux is that currently the Office of Federal Housing Enterprise Oversight (OFHEO) would only exercise conservatorship powers. A conservator can only step in to freeze everything in an insolvent company until things settle down a bit. But for a while now, OFHEO has been asking for receivership powers, which would give it the ability to actually liquidate a GSE if it ran into trouble.

Granting receivership power to OFHEO is viewed as an important move in many circles, although its precise effects are still hotly debated. The most compelling arguments in favor (all of which the Cranky Economist buys, to one degree or another) say that the move would telegraph to the markets that Congress really is willing to contemplate allowing one of the GSEs to go under in an orderly fashion. This message would countervail the "implicit subsidy" markets think is there right now, and might lead to more market discpline of the two enterprises, thus reducing the risk that OFHEO would ever need to use its receivership powers. Particular if the move came as part of a larger legislative effort to clarify exactly how one of the enterprises would be allowed to fail if they ran into trouble, it could introduce more certainty into the marketplace, and we could all sleep better at night.

The main argument against is that, by tinkering with the "implicit subsidy," granting receivership would only make the markets more skittish precisely because it would be evidence that the Congress was contemplating the failure of either or both of the GSEs. This doesn't make a lot of sense to me. The markets ought to be skittish already -- recent accounting woes have provided ample proof that the GSEs may be on shakier ground than anyone appreciates. And that "implicit subsidy" is just that: implied. Although investors assume the government would do something to bail them out of their irresponsible investments, no one knows precisely what. Creating receivership powers would create more certainty, always a good thing in financial markets.

So those are the big Greenspan stories. He favors forcing Fannie and Freddie to reduce their internal investment portfolios. And, just as significantly, he favors granting OFHEO receivership. Not bad for a morning's work.