There is a new battle brewing in Washington, one which is plainly impacting the largest players in the lending game. The catch is that when elephants in real estate rumble, interest rates may change.

The Department of Housing and Urban Development has proposed upping low-income "goals" for Fannie Mae and Freddie Mac, the nation's two largest mortgage buyers. Between 2005 and 2008 says HUD, the two mortgage giants must target their purchases to include more loans in three areas:

• Fannie and Freddie must purchase more low- and moderate-income loans, the goal will increase from 50 percent to 57 percent of the mortgages they purchase.

• For underserved areas, the current 31 percent goal will be increased to 40 percent.

• For special affordable housing programs, the goal moves from 20 percent to 28 percent.

In effect, Fannie Mae and Freddie Mac are being told to focus their financial power. If you're a lower-income buyer in an historically underserved area seeking to buy an affordable home, local lenders would love your business, knowing that Fannie Mae and Freddie Mac are virtually obligated to buy the loan.

Alternatively, if you're an upper-income buyer seeking a new mini-mansion in an exclusive subdivision, you don't fit the profile outlined by HUD. Happily, there are private lenders and secondary lenders who will vie for your business. But with less competition from Fannie Mae and Freddie Mac, will interest rates remain low?

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs), entities that were once part of the federal government but are now owned by shareholders. Fannie and Freddie operate in the "secondary market" where they take investor dollars and buy mortgages from local lenders. The lenders then use the funds they receive to make more loans and the process is repeated.

The secondary market is important because it means mortgages are available nationwide with uniform terms. We never have a mortgage shortage in one state or another, in large measure because of the secondary market.

Over the years Fannie and Freddie have generated huge profits for shareholders even while receiving substantial government benefits. How much? A study by the Congressional Budget Office pegs the value of federal subsidies last year at $23 billion.

HUD has the right to impose standards because in exchange for carrying out certain public purposes "the GSEs are accorded various privileges that provide them with some advantages not available to other private corporations, including an implicit benefit that allows them to borrow money at rates which are lower than rates competitors must pay."

Many investors believe the government would step in to "save" Fannie Mae and Freddie Mac if they had problems, a belief which suggests less investor risk. As Federal Reserve Chairman Alan Greenspan explains, "this view is widespread in the marketplace despite the privatization of Fannie and Freddie and their control by private shareholders, because these institutions continue to have government missions, a line of credit with the Treasury, and other government benefits, which confer upon them a special status in the eyes of many investors."

You can see the HUD goals from several perspectives:

• The goals may force Fannie and Freddie to liberalize loan standards to buy the required percentage of loans. Looser standards represent more risk, making it harder to raise capital on Wall Street while perhaps lowering profits. Or:

• Loan standards have been liberalized over the years with few problems and the new HUD goals reflect a re-evaluation of lending risk. But:

• Goal-setting is inherently messy: If you don't make the goal you have somehow "failed," if you do make the goal it will be higher the next time.

Why the new numbers from HUD? Part of the answer, at least, was explained clearly in HUD's proposal:

"The GSEs have generally lagged, not led, the overall primary market in providing financing for affordable housing to low- and moderate-income families, underserved borrowers, and their neighborhoods, indicating that there is more that the GSEs can do to improve their performance."

The HUD proposal, if put into effect, does not get at the central issue concerning Fannie Mae and Freddie Mac: Why are these companies receiving special federal benefits at all? Other companies in the secondary market are not so blessed and yet compete, make profits, pay taxes and meet all regulatory standards. Why not Fannie Mae and Freddie Mac?

It's time to free the Washington Two, to send them out into the world in the same way that children must eventually leave home. There will be some adjustment and discomfort, but there comes a time when parting ways is the choice that must be made.

Rather than simply cutting the cord, however, why not have a staged transition over several years? A gradual phasing out of the GSE limbo would have the smallest impact on Freddie and Fannie investors, allow the marketplace to decide how these companies should be valued, end the implied federal support that is now seen by many and put a stop to government quotas, an inherently bad idea in a world with changing markets.

Fannie Mae and Freddie Mac may begin to look at the HUD goals and see that such federal interference reduces the profit-potential for both firms, an issue for shareholders and perhaps an increasingly-good reason for the GSEs themselves to join those calling for privatization.

For more articles by Peter G. Miller, please press here.

Published: May 18, 2004

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