|What to Do With Fannie and Freddie?|
The need for reform is obvious and a return of private securitization may be the only option.
Every couple months, the trials and tribulations of Fannie Mae and Freddie Mac (collectively known as the Government-Sponsored Enterprises, or GSEs), appear on the national radar. This typically happens around earnings season, when staggering loss numbers are announced.
Once hailed as critical components to a robust housing market and easy access to mortgages for low-income Americans, the growing sentiment of many inside housing finance is that the two mortgage giants should be fitted with toe tags.
Maybe it's because policymakers aren’t sure what to do with the troubled companies, whether they should be publicly or privately owned. Perhaps it's because of the staggering amount of money they’re losing: The GSEs are beyond broke, burning through $150 billion in taxpayer money to remain solvent. Last month, Freddie requested billions more after reporting its 12th straight quarterly loss.
Before delving into the quagmire that is “what to do about the GSEs?” a brief history lesson is in order. Fannie Mae was established by the federal government in 1938 to create a liquid secondary mortgage market that would allow loan originators to focus on creating more loans. Essentially, Fannie bought mortgages from lenders so that lenders could use the cash for new loans (sounds like the foundation of a bubble, or at least inflation, doesn’t it?)
By 1968, the federal government released Fannie into the wild when it morphed into a private, shareholder-owned corporation. By 1970, Fannie was authorized to purchase private mortgages in addition to federally insured mortgages, such as FHA and VA mortgages. That same year, Freddie Mac was created to provide some “free market” competition for Fannie. Importantly, while they were technically outside the government umbrella, the GSEs carried an implicit guarantee from the US government. That is, investors in Fannie and Freddie debt were led to believe that any repayment problems would be cleaned up by the federal government.
Though both were publicly traded companies, the federal government routinely passed regulations specifically directing their actions. In 1989 the government passed the Financial Institutions Reform, Recovery, and Enforcement Act, subjecting both to oversight by HUD (the US Department of Housing and Urban Development).
In 1995, more than 10 years prior to the peak of the housing bubble, Congress granted the GSEs affordable housing credits to encourage the purchase of subprime mortgage securities.
By September 2008, as the housing market was in the throes of collapse, the GSEs were placed into conservatorship under the Federal Housing Finance Agency and have since been kept alive by regular injections of taxpayer money. So why are the GSEs even necessary? Why not just shut them down? Perhaps it's because of how important a role they currently play in the financing (read: propping up of) the US housing market: Fannie and Freddie were the buyers of more than 70% of mortgages issued last year.
Essentially, the GSEs buy loans from mortgage originators, paying in cash or exchanging the mortgage for a mortgage-backed security comprising those mortgages. By doing this, Fannie and Freddie enable lenders to quickly sell their loans and use the money to make new loans.
The GSEs will also issue guarantees that mortgages will be repaid, which act as insurance against borrower defaults. Both companies also issue mortgage-backed securities that come with a guarantee that the principal and interest payments will be paid on time to the investor.
The GSEs earn income from the interest-rate spreads between what they pay investors to buy their securities and the interest collected on mortgages underlying them, as well as from fees for guaranteeing loans and assuming the aforementioned risks related to defaults.
The latter is why the GSEs were crushed when the housing market fell apart. When borrowers default on loans guaranteed by Fannie or Freddie, the GSEs owe the entire balance of the loan or guaranteed security. Now, explicitly not just implicitly, US taxpayers are on the hook for GSE losses resulting from mortgage defaults and home price declines.
Calls for reforming Fannie and Freddie are growing ever louder. However, despite these calls no right solution seems to exist. Moreover, it seems unlikely that any real resolution to problems with Fannie and Freddie will take place before November. Treasury Secretary Timothy Geithner has promised to deliver a proposal for housing finance reform to Congress by January 2011. Conveniently after the midterm elections in November.
As long as it's politically unacceptable to tackle this gaping hole in housing reform, the only thing that can save the GSEs is the return of private securitization. Which, as it turns out, may not be as far off as most “experts” think.
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