Fannie Mae and Freddie Mac have been in the news a lot recently. But just what are these entities? Are they government agencies or private corporations? It seems that few media pundits or even politicians really know. But what everyone does seem to know—or at least, opine—is that we can’t let these institutions fail.

Why not?

To answer that question, we have to first establish just what Fannie and Freddie are, and what kind of impact they’ve had, on the economy in general and the housing sector in specific, since their inception.

Appropriately, the recent mortgage meltdown, which many experts see as a leading indicator of an emerging depression, has its roots in the Great Depression and its cousin, the New Deal. In an effort to increase home ownership, the FDR administration created the Federal Housing Administration (FHA) in 1934. The FHA set mortgage guidelines and offered federal insurance on mortgages that adhered to its criteria. The purpose of this was to “standardize” the terms of mortgage contracts so they could be easily “bundled” into securities.

Here’s what that means: if I, as a private investor, had today’s equivalent of $300,000 to invest in 1920, I’d have a few options. I could go into the stock market. I could buy commodities. I could invest in bonds. Or I could—theoretically, at least—purchase a mortgage from a bank. If I bought the mortgage, then I, and not the bank, would receive the monthly mortgage payments from the mortgagor; and I, not the bank, would have a claim on the property if the mortgagor failed to pay.

This could be an attractive investment to some people who wanted a good yield and a gradual return on their principal rather than semiannual interest payments with the principal repaid in one lump sum at the end of the loan, as most bonds work. However, the risk that an individual mortgagor would not repay the loan was great, and thus, prospective homeowners would be expected to pay a substantial premium, in terms of a higher interest rate, to compensate their lenders for the potential of total loss. Even if 99% of people repaid their mortgages dutifully, to the one investor in 100 who put up $300,000 and had his mortgagor skip town, the loss could be devastating.

Where It All Began

Enter the FHA. By offering an incentive to standardize the terms of a mortgage contract, large financial firms could “bundle” several similar mortgages together, and then sell debt instruments backed by those mortgages. Instead of investing in 100% of one mortgage, an investor could invest in a piece of ten or 100 mortgages. Not only would the default risk be spread out but so would the pre-payment risk—the risk that the borrower would repay the loan too quickly, thereby wasting the lender’s time. Thus, the premium lenders needed to charge on mortgage loans dropped, and homeownership became more affordable and widespread.

Sounds great, right? Well, the problem is that private companies did not step up to the plate and bundle these FHA-insured mortgages. The fact that they didn’t should have indicated the plan wasn’t so sound, but like most government programs, the FHA led to the creation of yet another government program: the Federal National Mortgage Association, FNMA, or cutely known as “Fannie Mae.” Fannie Mae was, at first, a government agency empowered to purchase FHA-insured mortgages, bundle them and sell the resulting debt instruments to the public. If these debt instruments went bad (i.e. if there was widespread default by the mortgagors), then it was always implied that the federal government would step in and cover them.

Between 1938 and 1968, Fannie Mae had a virtual monopoly on the secondary mortgage market. This should have come as no surprise as government has the monopoly on creating monopolies. But in an effort to inject competition into the market, Fannie Mae was privatized and empowered to buy any mortgages—not just FHA-conforming ones—and a second cutesy GSE (government-sponsored enterprise), “Freddie Mac” (the Federal Home Loan Mortgage Corporation or FHLMC), was created to compete with Fannie.

Where We Are Now

Fast forward another forty years and the chickens are finally coming home to roost. Both Fannie and Freddie are essentially bankrupt and their stock prices were headed to zero, kept afloat only by the implied government bail-out that was all but guaranteed to come. In one day, as Fannie and Freddie hit their all-time lows, a few words by Fed Chairman Ben Bernanke sent the stocks soaring, and $6 billion in market cap was added to the ailing GSEs. Republicans and Democrats, with very few exceptions, all agree that these firms must be “saved” and “not allowed to fail.” But the Austrian take on the matter is that these institutions have been positively disastrous to the freedom and prosperity of Americans.

There can be no doubt that the existence of the FHA, Fannie Mae and Freddie Mac has made homeownership more widespread. Most people take it as a given that this is a positive thing. But is it really? There are plenty of costs that come with homeownership versus renting—homeownership is not an unequivocal good.

Economic conditions in the U.S. and around the world have been destabilizing communities. Mobility is king now. People do not work at the same job for fifty years and then retire with a gold watch, proverbial or otherwise. By making homeownership artificially cheap, millions of Americans have been lured into buying when they should have been renting. This is one of the causes of the mortgage meltdown, as people who’ve lost their jobs and need to move can’t get out from under their upside-down mortgages.

The problem with government intervention into the economy is that, even if it seems to work in the short-run, it never takes the long-run into consideration. It can’t. The free market is dynamic and responds to change. If politicians who say they value the free market are true to their claims, they should at least consider allowing Fannie and Freddie to fail.

For arguments in support of increased government regulation on Fannie Mae and Freddie Mac, read G.L.C.’s blog post, “Fannie Mae & Freddie Mac: When Will the Government Learn?”