In their heyday as lords of the mortgage market, Fannie Mae and Freddie Mac practically minted money for shareholders, in part because their status as “government sponsored enterprises” gave the financial markets confidence that Washington would never allow the huge firms to fail.
That confidence – which would prove partly well-founded when the government stepped in to bail out Fannie and Freddie during the financial crisis, but allowed shareholders to be nearly wiped out – enabled the two companies to borrow money for less than their private sector competitors, making it difficult or impossible to compete with them.
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A new proposal from the two top members of the Senate Banking Committee, Chairman Tim Johnson (D-SD) and Mike Crapo (R-ID), would do away with Fannie and Freddie in order to make room for private sector competitors, but would retain the government guarantee. This time, however, the guarantee would be explicit and, unlike Fannie and Freddie, the private sector firms taking their place would have to pay for it.
“This proposal includes an explicit government guarantee in order to add stability to the economy, keep costs reasonable for borrowers and renters, and ensure fair access to the secondary market for all lenders,” said Johnson. “We also include important provisions that will preserve the 30-year mortgage as well as fair and affordable housing options for buyers and renters alike.”
Johnson and Crapo envision gradually eliminating Fannie and Freddie by creating a private market alternative, underpinned by a government agency that would sell mortgage bond guarantees – similar to the way the Federal Deposit Insurance Corp. uses assessments on banks to fund deposit insurance. The plan would insulate taxpayers from losses due to mortgage defaults by placing investors in a “first loss” position, meaning that before insurance coverage even kicked in, they would have to absorb a specified percentage – likely 10 percent – of the lost value from their own capital.
Some critics suggest that by replacing the implicit government guarantee with an explicit, fee-based insurance program, the plan will drive up the cost of mortgages, making home ownership less affordable. The plan might also reduce homeownership somewhat, because in eliminating Fannie and Freddie, it would also do away with their mandate to expand homeownership to lower- and middle-income borrowers.
The plan, which will likely take years to implement, answers calls from the private sector and from many on Capitol Hill to reform the two GSEs. Those calls have been coming since before the government stepped in to bail out the mortgage giants during the financial crisis.
However, the plan is not guaranteed a hearing in Congress this year. Influential Senate Banking Committee members such as Sherrod Brown (D-OH) and Elizabeth Warren (D-MA) are said to be opposed to it, and Senate Majority Leader Harry Reid (D-NV) has not said whether he would consider bringing it to the floor.
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Fannie and Freddie’s contribution to the mortgage market is not the making of loans, but the purchase and securitization of a limited range of loans. When a mortgage lender makes a loan that meets certain criteria, Fannie and Freddie will buy the loan. This adds liquidity to the market, because by returning the principal amount of the loan to the bank plus a premium for costs and future interest payments, the transaction allows the bank to make more loans with, essentially, the same money.
For their part, the GSEs fund their purchase of loans by packaging large numbers of mortgage loans into securities and selling shares of them to investors, who receive a stream of income from the interest and principal payments made by the original mortgage borrower.
In general, it’s a stable and fairly safe line of business. Well-underwritten mortgages have a predictable rate of return and low default rate. In fact, Fannie and Freddie found themselves in trouble during the financial crisis not primarily because of loans that they had purchased but because of a market-wide crisis triggered primarily by the meltdown of loans that neither GSE had been allowed to purchase in the first place.
The government invested about $188 billion to save Fannie and Freddie from bankruptcy during the financial crisis, and the two companies have since paid back $203 billion and are projected to add another $180 billion to the Treasury.
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So, why would the government want to divest itself of a moneymaker like that?
There are a number of reasons, but one of the biggest is that many policymakers simply believe that it is unfair, when private sector companies are willing and able to offer a similar product, to enable a government-backed entity to use its privileged position to dominate the market.
Another concern is that, while the bailout worked this time, next time it might not. There is no guarantee that the mortgage market GSEs will continue to turn a profit, and many policymakers believe the government shouldn’t put itself on the hook for another bailout.
Johnson and Crapo said that they expect to begin considering their bill in the Banking Committee “in the coming weeks.”
“Chairman Johnson and I have produced a comprehensive, bipartisan plan that winds down these too-big-to-fail entities, protects taxpayers by putting strong capital in a first-loss position, and provides broad access to mortgages for eligible borrowers,” said Crapo. “There is broad support to fix our flawed housing system, and today’s actions are a strong step toward ending the status quo.”
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