Fannie and Freddie Face the Future

Washington at last has produced some answers for the crippled mortgage giants, Fannie Mae and Freddie Mac.1 It has been a long wait—almost five years since the Treasury had to rescue them during the crisis of 2008 and two years since the White House issued vague speculations on their future. But even these latest, more comprehensive recommendations from the Housing Commission of the Bipartisan Policy Center fail to address all concerns about the mortgage market. And even with something more concrete, definite legislation clearly is still a long way off. In the meantime, mortgage markets will lack firm institutional support and depend entirely on the Federal Reserve's low-interest rate policy.

Up until Fannie and Freddie collapsed in 2008, these so-called government-sponsored enterprises (GSEs) served as the main support for the U.S. mortgage market and, thus, the country's housing market as well. The GSEs brought substantial capital and expertise as they worked with private lenders to securitize pools of mortgages and sell them to investors. Until this system failed, it seemed to work well on the basis of three assumptions, now obviously erroneous: one was the widespread belief that real estate was a secure investment with limited downside risk. A second relied too heavily on diversification, contending that a variety of mortgages backed by a variety of properties all but eliminated default risk, even when many borrowers had dubious credit. It was on the basis of this false assumption that the credit rating agencies glibly gave triple-'A' status to pools of subprime mortgages. The third erroneous assumption was that the two GSEs offered implicit, if not explicit, government guarantees.

When all these comforting assumptions proved false in 2008 and the GSEs failed, the Treasury took them over, putting taxpayer monies at risk. At the last accounting, that risk amounted to $137 billion, though recent gains in the housing market have improved both Fannie's and Freddie's cash flows, hinting that the loss ultimately may not be so severe.2 Even if in the end an improving real estate market erases the entire loss—a dubious prospect to be sure—it is clear that the nation cannot return to the old arrangements. After much delay, this latest report from a bipartisan group of former senators and housing officials is the most definite and comprehensive set of proposals yet.

The report reaffirms the need to support low-cost, 30-year mortgages in this country.3 To avoid the pitfalls of subprime buying, it also emphasizes the need for an active rental market for lower-income people. It would encourage rental development primarily by preserving and expanding the government's existing Low Income Housing Tax Credit Program. The group would phase out Fannie and Freddie gradually over a period of five to 10 years and replace them with a single entity, more efficient, the report claims, because it could combine the separate operations of the two predecessor GSEs. Rather than buy and bundle mortgages, as Fannie and Freddie have, this new consolidated GSE would attract needed capital to the mortgage market through an insurance scheme. It would explicitly guarantee the mortgage-backed securities issued by private lenders. To support more needy parts of the market, it would only back pools of smaller mortgages, less than $300,000. To protect the taxpayer, it would insist that issuers seek private insurance and would pay on its guarantee only after private insurers had exhausted their resources.

The proposals still leave questions unanswered. Among them is how the insurers, private and government, would assess risk. The record of 2007–08 certainly shows how Wall Street misjudged risk wildly. There is little indication to date that techniques or insights have improved. Any such failure to price risk properly in the new scheme could lead to unplanned premium hikes or catastrophic failures or both. Questions also remain about lenders gaming the new system, pooling their mortgage loans, for instance, to just fit within federal insurance guidelines, much as they did prior to 2008 to secure high ratings from the credit evaluation agencies.4

Even with such unanswered questions, mortgage lenders and homebuilders have welcomed the proposals. Though the premiums on the proposed insurance, the report estimates, would add some 25 basis points to the average mortgage rate,5 they welcome the prospect of continued government support and, after this long hiatus, something definite out of Washington. A typical response is that of Frank Keating, president and chief executive officer of the American Banking Association. He referred to the report as "strong," lauded the course it "charts," and gave special praise for its effort to make government involvement "explicit, paid for and limited." Official Washington has been more reserved. Typical here are remarks from Senator Bob Corker (R-TN) and member of the Senate Banking, Housing and Urban Affairs Committee. He described the report as "headed in the right direction," implying that matters were far from complete. He dispelled any hope that those proposals would be adopted wholesale by thanking those who produced them for "their contribution to the conversation." He expressed only a "hope" that Congress would produce "long-term reform this year."

So, the wait for a definite structure will go on, and uncertainty will linger in the interim. Chances are that elements of these proposals should find their way into the final reform legislation. After all, the report's emphasis on rental housing for the lower end of the income distribution mirrors White House remarks of two years ago, as does the plan to phase out Fannie and Freddie. The scheme also has the appealing quality of offering the taxpayers some protection. While market participants wait, perhaps for a still-long interim, they will have to rely for support on the Fed's willingness to keep interest rates and particularly mortgage rates artificially low.

1 Fannie Mae is the Federal National Mortgage Association and Freddie Mac is the Federal Home Loan Mortgage Corporation.

2 Vicki Needham, "Report: Eliminate Freddie, Fannie and Increase Private Involvement in Housing," The Hill, February 25, 2013.

3 For details, see Nick Timiraos, "Debating Future of Fannie and Freddie," The Wall Street Journal, February 25, 2013.

4 For details, see Nick Timiraos, "Six Questions on the Latest Fannie, Freddie Overhaul Proposal," The Wall Street Journal, February 27, 2013.

5 Nick Timiraos, "Fannie, Freddie to Make Joint Mortgage Company," The Wall Street Journal, March 5, 2013.

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