In 2008, Fannie Mae and Freddie Mac were placed under government control, and now Washington is looking for ways to relinquish at least some of that control to the private mortgage market. Yet, deconstructing Fannie and Freddie and limiting government influence in the mortgage market won't come without significant change and increased costs.
Fannie Mae and Freddie Mac were originally created to promote home ownership in the U.S. by facilitating the sale of mortgages to private investors. For years they did this successfully and responsibly, but many now believe these government-sponsored enterprises (GSEs) ran unchecked in the years before the financial crisis, promoting risky loans, inflating housing markets and ruining mortgage investors.
A mortgage market without Fannie and Freddie
It is a common sentiment that Fannie Mae and Freddie Mac cannot remain as they are. However, getting consensus on what should happen to these mortgage giants is a much harder decision.
At issue is the hybrid public/private model of the GSEs. On the one hand, they have operated as publicly-traded corporations with a private-sector appetite for risk and profit. On the other hand, these institutions long benefited from the implicit backing of the U.S. government.
The Obama administration put forward its plan in a February 2011 white paper by the U.S. Department of Treasury, "Reforming America's Housing Finance Market." The report advocates increasing the market share of private mortgage lending companies while carefully reducing the role of Fannie and Freddie--with the ultimate aim of winding both institutions down.
The administration's vision is limiting the role of government "to robust oversight and consumer protection, targeted assistance for low- and moderate-income homeowners and renters and carefully designed support for market stability and crisis response."
3 proposed options under debate
So what might the mortgage industry look like with scaled-back government involvement? Three choices were put forth in the Treasury's report:
1. Limit the role of government to running the Federal Housing Administration and other programs targeted to creditworthy lower- and moderate-income borrowers. The advantages of this choice include making private financial institutions bear the consequences of their own lending decisions and limiting taxpayers' exposure. The disadvantages include higher mortgage rates and costs for those who do not qualify for FHA loans (though one stated goal of the plan is to make sure that the "majority of borrowers" do not qualify for FHA financing).
2. Limit the role of government as in the first option, but include a government guarantee institution that would step in to extend mortgage credit on a wider scale in times of financial crisis. The idea is to make a government guarantee sufficiently expensive that it would not be a viable choice except when other forms of credit have dried up. This option provides a safety net since private lenders tend to make credit very hard to get just when it is needed most--possibly exacerbating an economic downturn.
3. Limit the role of government as in the first option, but offer government reinsurance that would lower risk to holders of mortgage-backed securities. Under this plan, private mortgage guarantors meeting strict regulatory requirements would pay premiums for government reinsurance against the possibility of its shareholders being wiped out. This plan would protect investors who buy mortgage-backed securities, adding a layer of safety to the secondary mortgage market that would likely keep mortgage rates low. With more investors in the mortgage securities market, the traditional 30-year fixed-rate loan should remain available. This option would also provide a more competitive playing field for smaller mortgage lenders and community banks by allowing them to easily sell their loans.
Home ownership for all? Not anymore
The Treasury's white paper is pretty explicit that reforms will make it tougher for people to buy and finance homes. According to the report, "The government must also help ensure that all Americans have access to quality housing that they can afford. This does not mean our goal is for all Americans to be homeowners."
More specific predictions are that, without Fannie Mae and Freddie Mac, 30-year fixed-rate mortgages--the most popular home loan in America--might become harder to find and more expensive to get. After all, investors prefer loans with adjustable mortgage rates rather than long-term fixed rates, which expose them to risk.
Interest-rate risk played a huge part in the demise of savings and loans in the early 1980s, when inflation trounced the value fixed-rate mortgages made at low mortgage rates. Private institutions prefer to avoid a repeat.
Likely outcomes for mortgage borrowers
The exact changes will be hashed out in the upcoming months--and with elections always looming in the background of Washington debate, even the proposed options may morph further.
However, it seems safe to assume that mortgage borrowing post-Fannie and Freddie will look something like this:
- FHA and other government-backed mortgages will be limited to the neediest segments of our society--those of low to moderate income.
- Private mortgage lenders will be taking care of the rest of us, working within the constraints of additional regulation and retaining more of the risk from the loans they originate.
- Fannie and Freddie will lower their loan limits, and their market shares will decrease. Down payment and mortgage insurance requirements will increase.
Although outcomes are uncertain, it looks like financing a home in America without Fannie and Freddie will be tougher and more expensive. What it means today is that it may be smart for those who are interested in buying a home to start the process now.
