The world post Fannie Mae and Freddie Mac, part one

Yesterday in a white paper entitled “Reforming America’s Housing Finance Market” the Obama Administration dared to consider the end of the sacrosanct real estate mortgage institutions of Fannie Mae and Freddie Mac.

In part one of a two part “What My Intuition Tells Me Now” blog piece I will review the importance of Fannie Mae and Freddie Mac, as well as consider the proposed changes outlined in the white paper.  In part two I will talk about the world post Fannie Mae and Freddie Mac.

In case you are unfamiliar with these two institutions, known as government sponsored enterprises (GSEs), they were created by Federal government mandate to ostensibly underwrite (i.e. backstop) mortgages in the United States.  The idea was that with the imprimatur of the backing of the Federal government behind your mortgage that lending institutions would be more willing to lend to borrowers who otherwise would not qualify for a mortgage.  These two GSEs were spectacularly successful during their history in creating a secondary market for mortgages – creating vast liquidity for lending institutions.

Freddie Mac, technically known as Federal Home Loan Mortgage Corporation (FHLMC), was created in 1970 to expand the market for mortgages.  Freddie buys mortgages, packages them together, and then sells them as (now notorious) mortgage-backed securities.

Fannie Mae, technically known as Federal National Mortgage Association (FNMA), was created in 1938 as a part of President Franklin Roosevelt’s New Deal legislation.  However, in 1968 the U.S. Congress chartered Fannie to also create mortgage-backed securities.

In 1968, when Fannie Mae was given its new charter home ownership in the United States stood at 63.9% of the U.S. population.  According to the U.S. Census Beureau, as of the end of 2009 (the last year for which data is available) home ownership was at 67.4%.  So despite Fannie Mae and Freddie Mac acting as one of the largest subsidies in the history of the United States, home ownership rates barely changed in the 40+ year history.

Not only that, but the two institutions were also at the heart of the creation of the real estate bubble whose popping led to the Great Recession.  Even worse, once the value of real estate declined with high velocity the Federal Government had to step in to prop up the two institutions.  So far, according to the Wall Street Jounral, taxpayers are on the hook for $134 billion!  Thus, it is no wonder that the two institutions are in the midst of an existential crisis.

In fact, the two GSEs have long been criticized by economists, politicians and financial industry folks.  While it may seem a no-brainer to eliminate the two institutions, they have been considered sacred for several generations.  In fact, last year the two institutions were responsible for underwriting 9 in 10 new mortgages.  Thus aiding the economic recovery.  So the dissolution of Fannie Mae and Freddie Mac is something that will be carefully considered.

What will the world look like post Fannie Mae and Freddie Mac?

The Obama Administration is proposing three options for phasing into a post-Fannie/Freddie world.  Here are some of the details about the three options:

1. A new plan that would backstop qualifying mortgages under a Federal reinsurance model
2. A more limited backstop that would only scale up in times of economic crisis
3. An ending of Federal mortgage guarantees beyond already extant governmental agencies, such as the Federal Housing Administration

In the Obama Administration’s white paper a gradual increase in the percentage down payment required in order to qualify for Fannie and Freddie backing was proposed.  Specifically, the two mortgage giants could only purchase loans where at least a 10% down payment was in place.  Right now borrowers can qualify for Fannie and Freddie backing even if they have less than a 10% down payment if they purchase mortgage insurance.

Another suggested change is an increase in the fees that Fannie and Freddie would charge lending institutions.

Reform is also put forth in the form of the two institutions lowering the maximum loan size that the two GSEs can purchase from lenders.  Right now the maximum amount of a mortgage is $729,750.  The white paper makes the recommendation of lowering the size to $625,000.

Each of these suggested changes is clearly meant to lower the risk in the mortgage markets.  This makes sense since the market for mortgages is worth a staggering $10.6 trillion!  Fortunately, the white paper also has undertaken reform of other Federal institutions, not just Fannie Mae and Freddie Mac.

Specifically, the paper proposes an increase in the mortgage insurance fees borrowers will pay to support the Federal Housing Administration (FHA).  You may know that the FHA ensures that lenders don’t go bankrupt.

The last major detail of the white paper is that the Obama Administration wants to consolidate under a single umbrella the various federal government institutions that oversee mortgages and lending.  This would simplify regulations and regulating.  Clearly a good idea, unless you are a federal government technocrat worried about your piece of the power pie.

But the Obama Administration goes even further and wants to also reform banking, in general.

For example, the Administration also advises requiring lending institutions to hold more capital (i.e. equity; i.e. have more “skin in the game”) to protect against further home price declines.  And thankfully, the white paper also calls on banks to have more conservative underwriting standards.

Clearly Fannie Mae and Freddie Mac are integral to the functioning of a goodly chunk of the United States’ economy.  However, it has long been argued, and I think convincingly, that the two institutions actually contribute to the overall risk of the mortgage market, as opposed to lowering it.

The reason is that a disproportionate share of mortgages have the implied backing of the Federal government in the form of Fannie Mae and Freddie Mac, not to mention the FHA.  Consequently, the price of taking on risks in underwriting the mortgages is lowered.  That means that underwriting standards are very likely lower than they would be sans Federal government backing.  I hold up as evidence the mortgage bubble and resultant Great Recession.

During the mortgage bubble the demand for real estate was increased because new buyers entered the market in droves.  Predominately those new buyers were folks who previously could not attain a mortgage.  But once the underwriting standards were lowered – in large part because it was understood that Fannie, Freddie and the FHA would be there in a moment of crisis – there were new, less financially sound buyers present.

My second piece of evidence is the very small increase in home ownership resulting from the creation of Fannie Mae and Freddie Mac.  In 1968, home ownership was 63.9%, while at the end of 2009, it stood at 67.4%.  So trillions of dollars have flowed through mortgage markets in the past 43 years, yet home ownership has only increased a paltry 3.5%.  But that’s just the point: trillions of dollars have flowed through mortgage markets.

The predominate effect of Fannie Mae and Freddie Mac is liquidity.  That is, banks can rapidly redeploy capital into new mortgages, courtesy of the Federal Government.  Except you do realize, the real courtesy comes from the U.S. tax payer.  I’m not so into that.  But if you are an executive at a bank it was a great time to be alive.

In part two I will talk about the world post Fannie Mae and Freddie Mac.

Jason