Structuring Fannie and Freddie
According to Constitutionally Mandated Free Market Economy

[Note posted on April 20, 2016: I wrote this memo four years before formally proving that a government-regulated lender (like Fannie Mae or Freddie Mac) is uniquely attained within a math-econ model of dynamic (long-run) general equilibrium of the economy with net-worth maximizing stakeholders - in a paper, entitled Coalitions of Borrowers and Lenders, Government-Regulated Lender, Interest Rate and Safe Central Bank in Equilibrium.]

June 3, 2009

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

Only the constitutionally mandated principle of free market economy should be used to formulate policies for Fannie-Freddie, banks and capital markets.[1]  Neither political party can oppose such policies.     

The founding fathers embraced the free market principle to engender freely set prices for goods and services. The colonists did not enjoy this freedom when forced (blackmailed) to supply real goods and services for currencies printed elsewhere.  They waged and won a war of independence.  After winning the war, they crafted the first ever written constitution to enshrine the free market economy.  They wanted their posterity to relish this freedom.  The principle of free market economy is synonymous with freedom.  This represents the American ethos.  When policies comply with such common ethos, no one can oppose or defy them.   

The constitutionally mandated free market economy prohibits blackmailing by some agents of the effective producers of real merchandize and service. The effective producers are also the taxpayers because they generate everyone else’s incomes and taxes. The blackmailing is euphemistically called moral hazard.  No matter how it is called, it is a restriction unconstitutionally imposed by some agents on the markets.

The current financial meltdown has exposed the gargantuan moral hazard planted by some agents in the banking and capital markets.  The meltdown has wiped out trillions of dollars of hard earned savings of the effective producers.  The government has willy-nilly printed new money for the same agents who have planted moral hazard in the economy.  Taxpayers are angry.  As representatives of taxpayers, the Congress and the President are naturally concerned.

The principle of free market economy should be used (a) to screen specious arguments proffered to perpetuate the deliberately planted moral hazard and (b) to frame moral hazard-free policies consistent with the constitution with respect to Fannie-Freddie:    

1.     Without Fannie-Freddie, home mortgage debt holders will face serious moral hazard (blackmailing) due to exorbitant costs of borrowing, as faced by students after Sallie Mae was privatized.  To avoid moral hazard, consistent with the constitution, Fannie-Freddie should, therefore, remain non-private. 

2.     But government control of Fannie-Freddie has planted another moral hazard with commercial banks and mortgage originators transferring as much as $400 billion of non-prime mortgage loans (made to homeowners who could not afford the loans) over the last few years to taxpayers. 

Policies consistent with the constitution should preclude both moral hazard problems. In addition, an urgent goal of policy must be to restore confidence of investors and taxpayers in the American home mortgage industry, government, banking and capital markets. 

The above requirements for policymaking imply that Fannie-Freddie should be chartered independently as profitable corporations with the following attributes announced transparently and publicly: 

1.     Fannie-Freddie will lend home mortgage loans at the Federal Reserve fed funds rate plus a spread of 2.5% to 2.75% only to those borrowers who can afford according to standard professional lending norms.

2.     Fannie-Freddie will be run by professionally independent staff and governed by an independent board of directors.

3.     Fannie-Freddie will pay fair dividends on investors’ equity capital. 

4.     Fannie-Freddie will buy (fund) no more than 75% of each mortgage loan.  The mortgage originators must retain (fund) at least 25% of each mortgage loan bought by Fannie-Freddie.

5.     All loans made to Fannie-Freddie by the Treasury or Federal Reserve will earn no more than the Federal Reserve benchmark lending rate. 

6.     Fannie-Freddie will pay more dividends on preferred stock than on common stock, whenever the companies can pay dividends on common stock.  Until common stock carries dividends, Fannie-Freddie will pay dividends on preferred stock equal to the Federal Reserve benchmark rate. 

7.     The Treasury will reimburse Fannie-Freddie any subsidy granted to home mortgage holders by the Administration or Congress. 

8.     The Treasury will immediately expunge the warrants that have served no purpose except to create confusion and total diffidence of investors in the government.  In fact, the warrants have panicked investors and eroded their trust in the US banking and capital markets.  The panic due to incoherent government policy has resulted in massive loss of investor wealth.     

9.     The Treasury will use the pre-conservatorship common stock price as a basis of conversion of recently infused taxpayer funds to common stock amounting to 49% equity with the remaining 51% generated from private investors through a public offer.  The common stock price prevailing now due to the whimsical warrants could not be a credibly fair price which would prevail if such warrants were eliminated.  This capitalization will be floated immediately to regain investor confidence in American governance, banking and capital markets.  Fannie-Freddie will exit conservatorship if this recapitalization is successful or soon after sufficient profits are earned by the entities to pay off enough of taxpayer capital to leave 49% of the fully capitalized Fannie-Freddie after the public offer. 

10.     At the time of exit from conservatorship, Fannie-Freddie will have 51% equity capital from private investors and 49% of equity from the taxpayers (through Treasury) to maintain no more than 90% debt and no less than 10% equity in either Fannie or Freddie. 

Sankarshan Acharya


PS: This is not meant to be an investment advice either in the broader markets or in Fannie or Freddie. The author is not responsible for any direct or indirect inference about investments from his articles. The reader bears the entire responsibility for his investment decisions.


[1]Acharya, S. (1991-2009): “OPTIMAL GOVERNANCE FOR PROSPERITY AMID STABILITY,

A New Economic Philosophy for Democratic Capitalism, Realizing a Common Dream – Free Market Economy,” http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf