Will someone please put Fannie and Freddie out of their misery?

By Mark Zandi and
May 7, 2015
Toll Brothers luxury homes are shown sold before construction is completed in Oceanside

Toll Brothers luxury homes are shown sold before construction is completed in Oceanside, California, August 20, 2013. REUTERS/Mike Blake

Federal Reserve Chair Janet Yellen’s speech on Wednesday made the case that the Fed’s policy response to the financial crisis has put the system on much sounder ground. Perhaps, but policymakers’ work is not over.

Something has to be done with Fannie Mae and Freddie Mac. These too-big-to-fail financial giants buy mortgage loans, package them into mortgage securities and guarantee investors in these securities against any losses if borrowers default on their loans.

The problem is that Fannie Mae and Freddie Mac are owned by U.S. taxpayers, who are thus effectively making most of the nation’s mortgage loans. They have been since the government had to take over the two mortgage-finance giants during the 2008 financial collapse.

A man stands outside Fannie Mae in Washington

Fannie Mae headquarters in Washington, February 21, 2014. REUTERS/Kevin Lamarque

Yet policymakers display surprisingly little urgency to fix the problem. The last Congress even failed to get a full vote on substantive reform legislation. The current Congress shows little intention of seriously taking up the issue, and the Obama administration has been largely mum.

The status quo has held because the housing finance system is functioning. Mortgage loans are being made. This is vital to the housing market and broader economy.

But the current system is untenable. It makes little sense that taxpayers should be shouldering most of the burden of financing almost $5 trillion in outstanding mortgage loans. Private financial institutions and investors are more than willing to take on much of this risk.

The system will likely become increasingly unable to provide mortgage loans to creditworthy borrowers. Borrowers are changing as the Latino and Asian populations rapidly expand and millennials come of age. Fannie Mae and Freddie Mac in government hands won’t be innovative enough to provide the mortgage loans these groups will need.

Because Freddie Mac is big but far smaller than Fannie Mae, it is unable to charge as high a fee for its services. This gap is set to get larger with the end of the Federal Reserve’s quantitative easing program, under which the Fed was buying lots of the two firms’ mortgage securities. At the very least, this means taxpayers aren’t getting all the profits they should from Freddie Mac. Worse, it may mean that Freddie Mac won’t be viable in the long run.

A pedestrian walks past a sign advertising new condominium homes for sale in South San Francisco

A pedestrian walks past a sign advertising new condominium homes for sale in South San Francisco, California, December 22, 2009. REUTERS/Robert Galbraith

Changing the system is critical but must be done judiciously. Nothing should disrupt mortgage lending today because the housing recovery is still fragile. Taxpayers should also end up with far less risk and private institutions and investors with far more.

Taxpayers need to continue to backstop the financial system against calamities like the financial collapse. With this backstop, mortgage rates will be far lower, which allows for more home ownership. The popular 30-year fixed-rate mortgage can remain widely available as well. But taxpayers should be compensated by mortgage borrowers for providing this service.

Any change to the system should also introduce more competition among the private institutions and investors that take on the risk of mortgage lending. More competition will lead to more innovation, and thus more choices for mortgage borrowers at lower interest rates.

Lower-income borrowers should continue to get a break in the future housing finance system. Taxpayers now subsidize mortgage loans to these people through Fannie and Freddie, but the subsidy is opaque and not nearly as effective in reaching these groups as it could be. Instead, the subsidy could be made through explicit and transparent reductions in mortgage rates for these borrowers.

Accomplishing all this is a heavy lift politically. Legislation anytime soon is unlikely. Further complicating matters are various lawsuits by legacy Fannie Mae and Freddie Mac shareholders, who believe the government inappropriately took their property when it took over the institutions. Their arguments seem specious, but until the courts settle the dispute, policymakers feel hamstrung.

Police tape marked as a Foreclosure Free Zone is seen outside the foreclosed home of Marie Elie in Elmont

Police tape marked as a Foreclosure Free Zone is seen outside the foreclosed home of Marie Elie in Elmont, New York, April 9, 2009. REUTERS/Shannon Stapleton

Yet serious housing-finance reform can be done without new legislation. To some extent, Fannie Mae and Freddie Mac’s regulator, the Federal Housing Finance Agency, is already doing it.

The agency requires Fannie Mae and Freddie Mac to share the risk when backing a mortgage loan with private institutions and investors. To their credit, the two firms are increasingly innovative in how and with whom they share risk. They need, however, to work on a set timeline to off-load most of their risk. Eventually, they should provide private players only a backstop against calamity.

Fannie Mae and Freddie Mac can reduce fees as they off-load risk. However, their fees should be designed to ensure that low-income households have the same access to mortgage loans in the future as they have now.

The Federal Housing Finance Agency also wants Fannie Mae and Freddie Mac to combine their platforms for turning mortgage loans into securities. Each firm now has its own way of doing this, which adds to the costs and also makes it difficult for others to compete. They should be required to construct a common securitization platform that they and other financial institutions can use.

A common platform would allow Fannie Mae and Freddie Mac eventually to issue the same mortgage security. In doing this, they would effectively become one institution; costs would be reduced and Freddie Mac would not become a liability.

There has been a lot of hand-wringing over Fannie Mae and Freddie Mac. Fixing these institutions is the last significant unfinished business from the 2008 financial collapse and Great Recession.

Washington gridlock will likely ensure that this won’t happen legislatively. But through resolve and guidance, the Federal Housing Finance Agency could accomplish this. The nation’s housing finance system would end up in a place that works well for taxpayers, homebuyers and the economy.

11 comments

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Why would any private investor in their right mind want to be a part of what the author is suggesting when legal stock holders of Freddie and Fannie are having their rights completely trampled over by the executive branch?

Posted by navymedstudent | Report as abusive

Fatally flawed with partner/players in the GSE Business Model hopelessly conflicted.

Impossible to fix. Fatal means death.

Posted by Richard_Davet | Report as abusive

He that observeth the wind shall not sow; and he that regardeth the clouds shall not reap.
… and do business with them?

Posted by T.L. | Report as abusive

Mark Zandi attempts to make a possibly valid argument using convoluted facts that don’t support his premise. Fannie and Freddie came about as private lenders were both unable and unwilling to service the private mortgage market. So why would this vacuousness author now believe that there is ample funds available for mortgages in a privatized marketplace? He also states that somehow Fannie and Freddie (I assume continuing to exist) should somehow still make sure money is available to lower income families for mortgages. Of course inherent in this availability is higher risk to a lender that a private lender may not wish to take. A lender can either refuse the loan, ask for a higher interest rate or cost shift a portion of the risk to more secure borrowers (if forced to lend by the Federal govt.)

Posted by pablo222 | Report as abusive

The writer is from Moody’s. The same outfit that gave CitiGroup and Bear Stearns a AAA credit rating as they were dissolving. This is an outfit with zero credibility.

Posted by AlkalineState | Report as abusive

Creditors pursuing Moody’s for fraud in multiple cases…

http://www.wsj.com/articles/SB1000142405 2702303914304579192343147508158

Posted by AlkalineState | Report as abusive

Clinton and his cronies made mortgage banking a racial vote-buying scheme and caused the 2008 collapse. He should be in PRISON.

Posted by LetBalanceCome | Report as abusive

Hahaha. LetBalanceCome, let’s see you back that up with actual data and information. Clinton? Seriously? I think you’ve been dipping into the AM radio talk-show sauce again :)

Posted by AlkalineState | Report as abusive

LetBalanceCome,

All those minorities failing on all their loans right?

Conclusions
In this paper we examined the effect of affordable housing legislation on the volume, pricing, and performance of securitized subprime mortgages originated in California and Florida in 2004 through 2006. Using a regression discontinuity approach, we find no evidence that the affordable housing goals of the CRA or of the GSEs affected any of these outcome measures. This finding is robust to the inclusion of various, to the sample of only full documentation loans, and to different bandwidths for the regression discontinuity specification. We also find that the majority of mortgages packaged into subprime MBS went to borrowers with high stated income: Average borrower income for such mortgages was about $100,000. While we provide evidence that Fannie Mae and Freddie Mac held substantial amounts of subprime PLMBS, and that their holdings of these securities played a significant role in their demise, the evidence in this paper refutes the claim that the affordable housing mandates were responsible for the subprime crisis. We hope our findings stimulate researchers to seek other explanations for the subprime securities boom.

https://research.stlouisfed.org/wp/2012/ 2012-005.pdf

Posted by pyradius | Report as abusive

Makes sense for private investors to get behind mortgage backed securities, but mortgage lenders focus selling to Freddie and Fannie. 3 steps to fixing mortgage industry:
1. If you sell mortgages you must invest in the mortgage securities not just sell them to Freddie/Fannie or other banking institution (Pay attention to online lenders).
2. Raise interest rates or institute a refinance change that requires lender to verify that borrower is actually equitable. (So here we need to be certain that appraisals are required on all refinances, and that lenders can’t refinance a borrower who doesn’t save money and still reduce his debt. Pay attention online lenders who focused on selling FHA streamlines to clients who needed to “skip a payment” to get by.)
3. Get rid of lead aggregators who deceptively target consumers. Anyone see the “Barbara Corcoran’s Brilliant Tip for Paying Off Mortgage” ad? Or how about the “President Obama Changes Lending Law” for HARP?

Posted by FinancialFun | Report as abusive

From time to time, these sorts of articles appear about Fannie Mae and Freddie Mac, insisting that something must be done. The mortgage market is still functioning. The government is making a large amount of money from the profits that Fannie Mae and Freddie Mac feed into the government.

It’s really those profits that are the current problem. The government botched-up the take-over of Fannie and Freddie during the financial crisis.

The government defacto nationalized the two companies without compensation to the shareholders. The government used the two companies to try to rescue the housing market. In fact, Fannie and Freddie were even used to subsidize parts of the banking system. Bank shareholders were rescued. Fannie and Freddie shareholders were abused. Now Fannie and Freddie have a different, new set of shareholders who bought the stocks more recently at depressed prices.

Those new shareholders claim that the current profits that the company is generating should belong to them. The old shareholders who were there when the companies were defacto nationalized, think that the profits should belong to them. If the two companies were not making any profits, no one would want to claim them.

Meanwhile the government in Washington does not want to officially nationalize Fannie and Freddie since that would add those companies’ trillions of dollars of debt onto America’s national debt.

So the situation continues. Expect more articles like this one in future years, unless the two companies stop making profits.

Posted by nose2066 | Report as abusive