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Imagining a Fannie-less, Freddie-less World Imagining a Fannie-less, Freddie-less World

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The Next Economy / The Next Economy

Imagining a Fannie-less, Freddie-less World

March 17, 2011

Democrats and Republicans have finally found something they agree on: Fannie Mae and Freddie Mac must die. The troubled government-sponsored enterprises were once untouchable fixtures in Washington. They also served as the mortgage market’s foundation, providing the liquidity and low interest rates on which both bankers and middle-class Americans have relied.

Funny how much can change in a few years. The political mood has turned against the congressionally chartered corporations, as their bailout has cost taxpayers more than $150 billion and counting. After nationalizing the two companies, the government owns or guarantees more than 90 percent of new mortgages, but the political climate in Washington suggests that the market will have to function without Fannie and Freddie in the years to come. How might a world look without them?

First, what do Fannie and Freddie do anyway? They help to ensure that banks and other lenders have money to fund mortgages. To do this, they buy and hold some mortgages and use those as collateral in selling bonds to investors to fund more purchases. They also securitize mortgages and sell the resulting bonds to investors. In each case, money moves from investors through the two corporations to lenders who, in turn, provide mortgages to homebuyers.

 

So, if Fannie and Freddie merely act as middlemen in the funding process, what’s the point? It’s simple: All of the bonds they provide to investors include a guarantee, for which they charge a fee.  The U.S. government had implicitly—and now explicitly—backed that guarantee.

Fannie and Freddie, in particular, need not exist for the government to back mortgages, however. A new agency could arise to only guarantee or insure mortgages, so that investors could continue to benefit from the safety that the two quasi-governmental corporations once provided to their bonds.

What would happen if the private market takes on all the mortgage risk instead? Nobody is quite sure, because the U.S. economy has existed with Fannie and Freddie for decades. Somehow, the mortgage market would adapt. But higher mortgage interest rates, higher down payments, and stricter credit standards may result if banks and investors take on the new risk. Some experts even fear that the 30-year, fixed-rate mortgage could disappear, which could make owning a home more expensive.

For these and other reasons, many participants in the housing market want a full government guarantee left mostly intact. Naturally, the National Association of Realtors is in this camp. Full government backing for traditional mortgages ensures that “low borrowing costs will be available for many young, middle-class families to realize the dream of homeownership,” said the Realtors’ chief economist, Lawrence Yun.

Mortgage-bond investors tend to agree. William Gross, cofounder and co-chief investment officer at bond-investing titan PIMCO, told a mortgage-finance conference last August that his company would buy only pools of privately insured mortgages that included 30 percent down payments. He predicted that mortgage interest rates would rise by multiple percentage points, which could price many middle-class Americans out of homeownership.

Yet a full federal guarantee may be off the table. Many Republicans oppose significant government interference in mortgage financing. Surprisingly, the Obama administration appears to agree. In February, the Treasury Department suggested three alternatives for a governmental role in housing finance, none of which would provide a full guarantee for most mortgages. Treasury’s policy report on housing finance suggested winding down Fannie and Freddie over the next decade and drastically shrinking the government’s role. Relatively few mortgages would merit full government backing, and those that do would likely come through initiatives targeted at low- and middle-income Americans.

Two of the Treasury’s three options would, however, provide partial guarantees. One would ensure that government guarantees are available when economic turmoil causes credit markets to freeze up. Then, mortgages could continue to flow even as the private sector clenches its wallet.

A second option foresees hybrid guarantees, by which private investors must first take losses on failed mortgages before the government absorbs more. This would resemble the sort of mechanism used in federally insuring bank deposits, by requiring mortgage holders to pay premiums into a fund so that taxpayers won’t get stuck with the bill. Mark Zandi, the chief economist at Moody’s Analytics, favors this approach. A paper released in February that he coauthored estimates that a hybrid system would raise mortgage interest rates by only a tenth of a percentage point while saving the 30-year, fixed-rate mortgage from extinction and keeping homeownership rates high.

Treasury’s third option envisions an entirely free market in mortgages, in which banks and investors endure all of the risk. Most advocates scoff at the notion that this would raise the price of mortgages. Alex J. Pollock, a longtime mortgage banker at the American Enterprise Institute, thinks that mortgage interest rates would rise by just 0.3 percentage points or less. Most free-market champions reject partial or hybrid guarantees, because they doubt that taxpayers would truly be protected. Political pressures, Pollock said, “will always force” the government to charge too little for its guarantee.

But free-market purists don’t have a monopoly on cynicism. Zandi worries that the market wouldn’t be able to handle the risks entailed in a fully private model, so bailouts would become inevitable. “If push comes to shove, if we ever got into a situation like we did back in September of 2008, the government’s going to step in,” he said.

Expect the debate over Fannie and Freddie to rage on for months, possibly years. On Capitol Hill, legislation might be offered this year or next, presumably in a compromise version tailored to a politically divided government. But any fundamental changes are unlikely to take effect for a long time. For one thing, the housing market—still fragile—couldn’t endure the shock of a new funding framework.

So for now, Fannie and Freddie will live on. But don’t get too attached. Over the next decade, they’re likely to fade into the sunset.

The author is an associate editor at The Atlantic.

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