Reforming Fannie and Freddie: A $6 Trillion Problem
Policy + Politics

Reforming Fannie and Freddie: A $6 Trillion Problem

iStockphoto/The FIscal Times

As the Obama administration struggles to draft a report to Congress on how best to overhaul Fannie Mae and Freddie Mac, industry and  public interest groups are promoting plans of their own for the two mortgage giants.

The proposals range from converting Fannie and Freddie into new chartered entities to privatizing Fannie and Freddie. After the housing bubble burst, leading to the worst recession since the depression, the government stepped in to secure the companies’ $6 trillion worth of U.S. mortgages in order to avoid an even worse financial calamity. 

The Treasury faces a Jan. 31 deadline under the Dodd-Frank law to make recommendations on the future of Fannie and Freddie, although the Fiscal Times reported last week that they may miss the deadline because of sharp divisions within the administration.  The stakes are high: economic growth, return of private capital to the housing market, resilience in the event of future crises and continued consumer access to a 30-year fixed-rate mortgage all hinge on the right strategy. 

Most interested parties agree on the basic outline of a new structure that would divide the functions of Fannie and Freddie between government and the private sector in order to shift the mortgage securities market back to private investors while ensuring Americans' access to affordable housing and credit.

Before becoming embroiled in the real estate collapse and financial crisis, the two government-sponsored enterprises for decades fueled the development of a liquid secondary mortgage market and kept capital flowing to American homebuyers. "The problems we have are what the government should be guaranteeing, what it shouldn't. None of those things really fundamentally involve throwing Fannie and Freddie out," said Guy Cecala, publisher of Inside Mortgage Finance. Congressional reform is likely to take at least two years, "given the precarious state of the housing market and mortgage finance overall."

The leading proposals for housing finance reform fall into three general categories: 

The Progressive Proposal.  The plan that many observers view as closest to the thinking of the Obama administration was drafted by the Mortgage Finance Working Group under the aegis of the Center for American Progress. It calls for the creation of new entities called chartered mortgage institutions (CMI) that would guarantee payment on mortgage-backed securities that met certain standards, in exchange for a fee. CMIs would take the first loss if borrowers defaulted. The government would regulate their capital and which products qualify, and would prohibit preferential treatment of a corporate affiliate.

Federal regulators could take over and wind down a CMI in order to protect the fund. The plan recommends that the government guarantee only that mortgage-backed security investors would be repaid but not bail out large, multi-function institutions. Other provisions would provide capital support for rental and affordable housing and encourage innovation to meet the needs of underserved communities. 

"At the end of the day, we want to make sure the system of the future provides access to credit for people who are ready for homeownership," said Sarah Rosen Wartell, executive vice president at the Center for American Progress.

The Industry Perspective
Both the Housing Policy Council and the Mortgage Bankers of America have offered plans that represent the thinking of many in the financial services industry, as have some individual banks. Similar to the Center for American Progress  proposal, new federally chartered institutions would be created to guarantee mortgage-backed securities.

The new firm's assets would be segregated from any parent company so that if it failed, a government guarantee would ensure that MBS investors would be repaid but not bail out the institution. The system would be funded by a fee on mortgage securities insurance companies and would include revenue for affordable housing.

Unlike the CAP proposal, Wall Street wants the new firms to be able to buy mortgages from banks and issue a new type of security backed by those mortgages, not merely sell insurance on the securities. The industry also wants the government guarantee to extend to a wider range of securities, such as those based on a class of "safer" mortgages outlined in Dodd-Frank.

"These would have to be fully documented on income, well-underwritten loans," said Paul Leonard, vice president of government affairs for the Housing Policy Council, stressing that the government guarantee only extends to the security, not the institutions. "Under our plan, we do not envision any institution being too big to fail."

The Conservative Proposal . At the other end of the spectrum are conservative Republicans and free-market groups that oppose extensive government involvement in the housing market. Last week a group of American Enterprise Institute scholars proposed a system in which only the highest quality mortgages are allowed into the securitization system, asserting that investors will then be comfortable extending capital without a government guarantee. Affordable housing programs would be funded directly by the federal budget in order to protect both homebuyers and taxpayers. And Fannie and Freddie would be privatized gradually, by reducing the loan limit to 20 percent a year, with the private sector stepping in to securitize mortgages larger than the limit. 

The government isn't well-positioned to price mortgage insurance or anything else, said Anthony Sanders, a professor at George Mason University who would like to see more discipline in the real estate market.

"Eventually, the U.S. has to return to the 20 percent down payment standard for loans. Households unable to accumulate the 20 percent down payment rent their dwelling and save for a down payment," Sanders said. "Otherwise, we are doomed to repeat bubbles and bursts in the housing market."