From Tanta at Calculated Risk. Read the whole thing. I’ll comment on some excerpts.

One of the issues that’s being bandied about is whether Freddie and Fannie can/should be allowed to fail. I think it’s a moot point. I think they already have failed, in the sense that I don’t think we’ll ever go back to the era of mortgage finance dominated by two giants with super-low borrowing costs. In the long run, their market share is going to be smaller, not bigger. From now on, their borrowing costs will almost surely include a significant risk premium.Now, on to Tanta.

I think it’s very difficult for people to grasp the primary liquidity function of the GSEs. They have always been about recycling lending capital and taking long-term fixed interest rate risk off depository (and eventually non-depository) lenders much more than about merely absorbing credit risk.

When I first started with Freddie, we held very few loans in portfolio. We sold most of our securities. The interest-rate risk did get shifted from the lenders, but we did not take that risk ourselves. We thought that made us less risky than Fannie, which held a ginormous portfolio.

Then around 1988 Fannie discovered convertible debt. For example, a ten-year bond that you could repay after five years if interest rates fell. Convertible debt was a great match for mortgage assets. That, along with the demise of the S&L industry and the evolution of capital requirements, made holding mortgage securities in portfolio very attractive. So Freddie grew its portfolio, too.

Tanta says,

both GSEs were major culprits in the growth of the mega-lenders. Over the years they were struggling so hard to maintain market share, they were allowing themselves to experience huge concentration risks. As they catered more and more to their “major partners”–Countrywide, Wells Fargo, WaMu, the usual suspects–they helped sustain and worsen the “aggregator” model in which smaller lenders sold loans not to the GSEs but to CFC or WFC, who then sold the loans to the GSEs. In large measure this was a function of pricing: the aggregators got the best pricing from the GSEs–the lowest guarantee fees, the best execution options–making it more attractive for a number of reasons for small lenders to sell to the aggregators.

This is an arcane but important point. Think of the lending industry as consisting of huge lenders, like Countrywide, midsize lenders like regional banks, and scumbag mortgage brokers, who would lend to anyone and sell to anyone. The scumbags included a lot of fraud-purveyors. But most of the time, although not intending to, the scumbags made good loans.

For Freddie Mac, dealing directly with scumbags was a scary proposition. You preferred to buy the scumbags’ loans from Countrywide, and then force Countrywide to repurchase the egregious loans that came through that channel. (You couldn’t force the scumbags to repurchase, because they didn’t have the capital–assuming you could even find them by the time the problems became apparent.) You delegated the quality-control function to Countrywide.

There was a constant internal argument about delegating QC that way vs. doing more of it in-house. As Tanta points out, one of the problems with delegating it is that you strengthen Countrywide’s position in the market place, to the point where the mid-sized players can’t even compete with them anymore.

Krugman thinks that the GSE’s stayed relatively clean during the sub-prime frenzy. I think otherwise. Tanta’s views are somewhere in between. HeShe writes,

In the schizoid reality of the GSEs, when they had their “shareholder-owned private company” hats on they did plenty of envelope-pushing. When they had their “affordable housing” hats on, they rationalized dubious theories of credit quality…to beef up their affordable housing goals, often at the expense not of the poor put-upon “private sector” but of FHA, whose traditional borrower pool they pretty thoroughly cherry-picked. Nonetheless, the immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum LTV of 80% unless a well-capitalized mortgage insurer took the first loss position, plus all their other regulatory strictures, managed fairly well against the irresistible force of “innovation.”

We can stipulate that the GSE’s probably had the capital to withstand credit losses from their typical book of business. But then, Tanta goes on,

the minute it looked like the party was over, Congress and the administration both fell all over themselves to push the GSEs into jumbo markets they had at least managed to stay out of during the worst of the boom, cheerfully lifting their portfolio caps at the same time. How do you go on a stock-selling binge at the same time you have just become the official lender of last resort (along with FHA), handed the mandate to take out all those toxic ARMs with too-large loan balances into “safe” 30-year fixed that the borrowers in question still can’t afford? If credit risk wasn’t, heretofore, mostly the GSEs’ problems, it will be now.

Live by your friends in Congress, die by your friends in Congress. Investors have only so much appetite for political risk.

Tanta then makes what Tyler Cowen calls a contrarian argument.

The irony of the “subprime” situation, it seems to me, is that we probably all would have been better off if the GSEs had gotten into it in a big way. If the GSEs had been able to create a market in “vanilla” subprime–fixed rates, no prepayment penalties, careful documentation requirements, competitive pricing–and forced their seller/servicers into a “subprime box,” the subprime loan market would have been a lot better off. The “pseudo-Maes and Macs” have never really been very good at providing the kind of market discipline within their purview that the real Mae and Mac have.

I agree that, other things equal, you’re better off having high-risk lending done by professionals than amateurs. But I’m not sure that other things would have stayed equal. I keep recycling the line, “There is no such thing as idiot-proof. They can always build a better idiot.”

In any case, it does not help for Congressfolks to complain about “reckless lending” on the one hand and complain about “under-served borrowers” on the other. Today’s under-served borrower is tomorrow’s reckless loan.

The scariest mortgage-market amateurs in the whole system are our elected legislators. That is what makes the government-sponsored enterprise model inherently unstable and unwise.