The Future of Fannie and Freddie

Home mortgage giants Fannie Mae and Freddie Mac opened for business yesterday not as the government-sponsored entities they once were but rather under direct government conservatorship. This dramatic semi-nationalization of America's primary home mortgage companies is justified under the circumstances given that nearly 1 in 10 home mortgage borrowers today are in trouble. And with the situation worsening, there is political consensus at least to keep the mortgage market functioning and avoid dire financial market ripple effects.

But momentary agreement among conservatives and progressives on a need for government intervention hardly indicates consensus on what should come next. As "Chicago school" economist Milton Friedman once famously declared: "Only a crisis--actual or perceived--produces real change. When the crisis occurs, the actions that are taken depend on the ideas lying around."

Many ideas about the role of government in the home mortgage market are lying around, but crisis also creates a risk that the politics of the moment might steamroll over the best policies for the future. Prescriptions for the future of Fannie Mae, and the Federal Home Loan Mortgage Corp, or Freddie Mac, depend on one's take on how the government-sponsored entities reached this point. By most accounts, the GSEs were not the source of the current widespread home foreclosure epidemic, which instead erupted from within the subprime mortgage portfolios generated primarily over the past eight years by Wall Street financial institutions outside of the Fannie/Freddie home mortgage system.

Many commentators, including me, noted the Bush administration's ideological aversion to regulating the home mortgage marketplace. By taking a largely hands-off approach toward the origination and securitization of high-risk subprime mortgages, the administration allowed home loans to be sold to borrowers who had no reasonable prospect of repayment except by forced sale if the home continued to appreciate.

Inadequate regulation of financial institutions--on their levels of debt, their capital reserves, and their off-balance sheet banking activities--further inflated a bubble of junk home loans. Government officials remained allergic to intervention in this out-of-control market even as the systemic risk to the larger system of payments became clear as so many investment and banking firms were overinvested in these high-risk securities. As more and more of those subprime mortgages went into foreclosure, house prices plunged, and previously stable borrowers also found themselves in financial trouble. More and more borrowers were making monthly payments on mortgages that exceed the value of their homes--a highly reliable predictor of default. The foreclosure infection spread widely, just after Fannie and Freddie, struggling to make up lost market share, moved into the so-called Alt A market of supposedly just below prime grade mortgages, many without documentation of borrower capacity to repay. Their regulator sat idly by.

If one concludes that the current housing crisis results heavily from laissez-faire ideology trumping common sense protection of safety, soundness, and consumers, then the logical remedy would be to require more effective regulation. This approach would start by stabilizing the GSEs through the appropriate actions being taken by the Treasury department--and then use them to rebuild a home mortgage market based on sound lending and securitization practices, effective oversight of private actors, and regulations to ensure that even private market actors act in ways consistent with the public interest. Over the long term, restructuring the GSEs would also require a rigorous system designed to better align who wins when there is profit, and who pays when there are losses.

This approach might involve following the lead of the Federal Insurance Deposit Corp, which is using its takeover of a major home mortgage lender, IndyMac Bank, earlier this year to showcase how emphasizing mortgage restructuring rather than foreclosure can reduce losses and mitigate the downward pressure on home values.

In this way, qualified low- and moderate-income borrowers who show low default rates when their mortgages are right-sized and originated with appropriate counseling and support would not now be sacrificed to Wall Street and governmental failures and again shut out of home mortgages. Yet conservatives are already pushing to "shrink-the-GSEs," perhaps as a precursor to fully privatize the secondary market for home mortgages.

For his part, Treasury Secretary Henry Paulson has advanced the view that the GSE model, not the failure of asleep-at-the-wheel regulators, is to blame for the crisis. "Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes," he said in a statement. "There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form."

But he also mapped out a medium-term plan, specifically stating that "to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size." But is size the central problem with GSEs? The Treasury statement suggests that the GSEs will be shrunk to a size where their systemic risk--that is, the number or character of parties who extend them credit or invest in them--makes them no longer too big to fail.

Problem is, the intertwined nature of global financial markets today requires regulators to intervene even in the case of smaller financial players from time to time when regulators fail to do their jobs--most recently in the March 2008 takeover of collapsing Wall Street investment bank Bear Stearns Cos. by J.P. Morgan Chase & Co., which required the Federal Reserve to pony up $29 billion in bailout money. And even if we only look to their role in making a market for home loans, how small would they have to get to matter little if they failed but still be able to benefit consumers?

There is no doubt that greater reflection on the perils of hybrid private and public objectives is required. But better regulation must be part of the answer. What's more, we have to consider what the system looks like if the GSEs are privatized. FHA has assumed a growing market share with the disappearance of the subprime market and Congress recently assigned to it a new and important role providing assistance to restructure at-risk mortgages. But its systems and personnel and innovative capacity is limited for such a substantial role--a role that would need to grow dramatically were the GSEs to fade away.

The need for government involvement to create widespread liquidity in the secondary market for home mortgages extends back to the Depression era. Creating 30-year, fixed-rate mortgages enabled many in the middle class to buy homes at affordable interest rates. Many of us today grew up in a first home bought with a government-guaranteed Veterans Administration or Federal Housing Administration loan--often on terms more affordable than the private market would extend, if we could have qualified at all.

Much of today's middle-class personal wealth (at least, prior to the recent sharp plunge in house values) is house wealth, enabled by access to a stable mortgage developed with government involvement over the past 70 years. This is a government role that should be preserved as the federal government works through its conservatorship of Fannie Mae and Freddie Mac.

The GSEs contributed greatly to their own undoing, misstating earnings and buying Alt A and subprime loans to securitize and resell into the secondary market, often keeping some of these securities on their own books. And the GSEs' regulators did not stop such excess risk taking. But we need to do more than just point to sins of management as a justification for the government completely disengaging from our mortgage finance system other than through generous mortgage interest deductions and homebuyer tax credits.

GSE reform that moves toward full privatization, without tougher regulation to protect consumers, tougher regulation of private financial institutional practices, and serious restoration of the capacities of FHA, would be damaging to individual homeowners and the financial markets. The critical focus instead should be on what mortgage finance market best benefits average American borrowers.

Would a fully privatized mortgage market incorporate protections needed at the loan origination stage to avoid more high cost? Would full privatization cause interest rates to spike even more on adjustable interest-rate mortgages? Would we see even more opportunity for credit originators to gain greater advantages over borrowers similar to the past eight years?

Or would home mortgage lenders instead incorporate the lessons of what works to provide stable, affordable mortgages to low- and moderate-income borrowers, learning from the mistakes made over the past decade by many responsible local programs. As Friedman went on to note about times of crisis, oftentimes "the politically impossible becomes the politically inevitable." The housing market plunge appears to be just such a crisis, demanding a progressive consensus be forged soon on the road to follow.

David Abromowitz is a Senior Fellow at the Center for American Progress. This post originally appear on the CAP website.

Comments

[Aaror]

What is hilarious to me is that the Repubs are salivating at taking these entities apart to give this business to other banks. What they are ignoring is that these entities help homes sell. If homes are harder to sell, prices fall. How did we get in this mess? Oh yeah, prices fell. Expect the shrinking of these entities to prolong the housing crisis for the forseeable future.
Of course, the shrinking of these GSE's, and the resulting losses in the housing market, will hurt the banks that are screaming to get the "unfair competition," out of their way, but nobody said wall street types were smart...

[Eafloaf]

Since the time of Emperor Constantine, through the Bessingerian Era, eonomists such as Marc Shaeffer have repeatedly pointed to the success of--what has variously been called--"self reliance", "sustenance" and, more recently, the "ownership society." Certainly Freddie and Fannie have made home ownership a reality for many who would otherwise be incapable of achieving that element of the American Dream. A friend of mine, James, who lives on a Pond, comments repeatedly that he would never be able to live in such a location were it not for the GSEs.

However, unbridled free marketeering while consistent with the Schloss School, leads to excesses that, in the interests of the greater good, require regulation. Query, didn't the original charter of the GSE's limit the investment pool to middle market residential mortgages? Was there no limitation as to Subprime Loans, on the one hand, or "Jumbo" loans, on the other? Clearly to have digressed from the middle market was a decision made with H.A.F. Only Justice Reeves would have been so bold as to have varied from the norm to such a degree.

There are those who listen to the Presidential candidates with regard to their positions on the GSE bailout and, as to McCain, simply remark "Let John get his gun...".

I'm sorry, Dave; pardon me, but, uh, I do not believe that any of their positions on this will help them get Mr. Michigan in the fall.

[Henry]

David,
Really? This is not as complicated as you think. Fanny and Freddie when operating within historical rules require "conforming mortgages" for their purchase(no subprime) Fannie & Freddie have no social or moral goals. FHA and VA and HUD programs pick this up. Fannie and Freddie borrow money at the UST rate of 3.5% and purchase bank orginated conforming loans to yield 6.0%. The spread is 250 basis points and this is it. What is so complicated about this picture? Your bank or credit union cannot make you a 30 yr fixed at 6.25% because their cost of funds can go from 2.0% to 20.0%!! But the GSE Fannie and Freddie can do this because they can avail themselves of the lowest rate in the market, the U.S, Treasury rates.
Now think about the brokers, investment bankers, appraisers, and the ratings agencies and imagine how this financial aides (of the subprime ciriss) impinges upon the GSE??? The GSE have been "expletive deleted" by the market. And Fannie and Freddie certainly have no place taking the moral high ground but if you know a scintilla about business, you know it is all about "policy and procedure". The conservative policy and procedures of Fannie and Freddie have put 10s of millions of Americans in homes who would not otherwise be there. Simple question: If they are "privatized" how do they get the Treasury rate? No Treasury rate preference, no business.... that simple.