Advertiser Disclosure

Fannie Mae and Freddie Mac: What Will Reform Look Like?

Aug. 19, 2013
At NerdWallet, we strive to help you make financial decisions with confidence. To do this, many or all of the products featured here are from our partners. However, this doesn’t influence our evaluations. Our opinions are our own.

Earlier this August, President Obama advocated a ‘wind-down’ of Fannie Mae and Freddie Mac over several years. The full speech is here.

What does this mean for the the major government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac?  Now that the worst of the mortgage crisis is behind us (we hope), and the market for houses is finally starting to recover, the effort to destroy Fannie and Freddie as we know them – for good or for ill – has become a bipartisan priority.

The President isn’t the first to make this proposal by a long shot. Former Treasury Secretary Tim Geithner also proposed substantially reducing the government-sponsored enterprise (GSE) footprint in the mortgage market. Earlier this year, Republicans in the House of Representatives pushed legislation that would effectively end Fannie and Freddie. And in the Senate, Bob Corker and Mark Warner have introduced legislation that would result in a substantial overhaul in how the government and private industry interact with respect to home mortgages.

Snapshot: A Bit of Fannie and Freddie History

To understand where we’re going, it’s useful to understand where we’ve been  – and how we got where we are.

In 1934, faced with a devastating liquidity crunch in the face of the Great Depression, Congress created the Federal Housing Administration and authorized it to create an entity that would provide a robust secondary market to help improve liquidity in the mortgage market. This entity was to purchase mortgages from banks and other lenders, providing them cash that they can turn around and lend again.

Congress then chartered the Federal National Mortgage Association in 1938.

In 1968, the government decided to split the entity in two. The Government National Mortgage Association (GNMA), or Ginnie Mae, remained within the government, while Fannie Mae privatized – at least in theory.

In reality, however, Fannie Mae investors – and borrowers, for that matter – benefited from a grand strategic ambiguity concerning the nature of a rumored government guarantee.

On the surface, there was no government guarantee. Small-time investors were put on formal notice, via their prospectuses and via the public statements of political leaders – that there would be no taxpayer bailout if Fannie and Freddie should come into a rough patch.

Nevertheless, many in the investment industry were getting a different message from Fannie and Freddie investment representatives, who would say, when questioned, ‘we both know the government will step in and shore up these investments.’ And so the theory of the ‘implicit guarantee’ of GSE investments was born.

As they say, one thing led to another, and when the collapse of the bubble created a loss of faith in equities, and the collapse coincided with a massive savings glut, largely from Asia, all that capital had to go somewhere. And so it did: It bid up real estate prices beyond all reason in the 2000s, and after a classic buying frenzy in which mortgage underwriting standards went out the window as lenders struggled to find productive use for the flood of savings coursing its way through the market, the whole house of cards collapsed.

And as it turned out, the implicit guarantee of Fannie and Freddie became explicit, as the taxpayer was forced to step in to prop up the two mortgage giants to keep liquidity from drying up completely.

Reform is Now a Bipartisan Priority

So now that the massive ‘implicit guarantee’ bluff has been called, many on both sides of the aisle are calling for a change. Republicans in Congress have called for the elimination of Fannie and Freddie as we know them, and now President Obama is also calling for something new.

“For too long, these companies were allowed to make big profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag,” the president said. “It was ‘heads we win, tails you lose,’” said the President in Phoenix last week.

Broadly, President Obama is calling for a slow rollback in the role of the GSEs in buying mortgages from lenders – over the course of about five years. Any less than that and there is considerable risk of a disruption in the stream of liquidity that banks rely on to allow them to keep lending.

In their stead, Obama is calling for a bigger role for private capital. In theory, the same investors that are now buying collateralized mortgage obligations for their pension funds, hedge funds and mutual funds can gradually shift their buying to purchase directly from lenders, rather than via the GSEs.

The President is also demanding that any deal he eventually signs “should preserve access to safe and simple mortgage products like the 30-year, fixed-rate mortgage.”

That’s where it gets dicey. The current market in which the 30-year fixed rate mortgage is a widely available staple of home lending emerged in an environment in which banks knew they had a ready buyer for their conforming mortgages, and the markets also knew that Ginnie Mae stood by to guarantee interest and principal on qualifying mortgages.

The 30-year mortgage may be safe for homeowners. But they aren’t very safe for lenders, absent that ready secondary market and government guarantee. Lenders take on a lot of inflation risk and a lot of interest rate and reinvestment risk lending over 30 years.

Moreover, the 30 year fixed rate loan doesn’t exist much outside of the United States. Without a Fannie and Freddie, most other developed countries rely much more on variable rate mortgages, or issue shorter loans with balloon payments – and the need to refinance every so often to roll the note over, or both.

Furthermore, while practices in Europe vary by country, there is generally some government backstop to keep liquidity flowing and to encourage lending.

The President, incidentally, has reversed course, compared to earlier Democrats. While Republicans had generally been pushing for an increase in fees charged to lenders to provide a guarantee, Democrats in Congress historically opposed the measure, seeking to keep end borrowing costs low to maximize growth in homeownership.  The President, however, is now calling for an increase in fees charged to the lender. From the New York Times story:

After years in which the formerly formidable Fannie Mae and Freddie Mac and their Congressional allies blocked proposals requiring some kind of fees or risk premiums, Mr. Obama is calling for an assessment to be paid to the government on the value of mortgage-backed securities.

Under his proposals, the revenue from an assessment would help finance aid for borrowers and the construction of houses and rental properties that lower-income Americans could afford.

Mr. Obama’s focus was homeownership. But he emphasized the need for more affordable rental housing more than he had before. Advocates have called for a “rebalance” of government subsidies, which they say have too long been skewed toward homeownership and mostly benefit the affluent.

“In the run-up to the crisis, banks and the government too often made everyone feel like they had to own a home, even if they weren’t ready and didn’t have the payment,” Mr. Obama said. “That’s a mistake we shouldn’t repeat,” he said.

“Instead, let’s invest in affordable rental housing.”

If policymakers still want to hang their hats on the 30-year fixed-rate mortgage as a mainstay of the American housing market, some significant role for government is a near certainty, even after Fannie and Freddie are completely wound down. The Center for American Progress details some of the ideas that seem to have found bipartisan support – chief of which is a new “public guarantor” that does not directly buy and sell mortgages, but simply guarantees payments, thus taking some of the risk out of the equation for lenders – for a fee.  A more detailed matrix of 26 competing proposals is here. Obama’s proposal is close to the Campbell-Peters proposal which has been floating around for a couple of years:

The mortgage market will be funded and propelled by private capital. There will be a government guarantee in place, and it will be explicit, not implicit. The government will operate a reserve fund, using capital from fees charged to lenders. The taxpayer will eventually backstop the reserve fund, as well – but only after all private investors have first been wiped out. Meanwhile, Fannie and Freddie are placed in receivership, and their total assets reduced to $250 billion or less within five years of enactment.

Congress probably won’t enact anything until 2015. There are competing proposals out there, but since this plan is the most likely to survive a presidential veto, we expect something close to Campbell-Peters pass. This is true even if Republicans manage to retake the Senate in the 2014 mid-terms.


Read More From NerdWallet: